Exploration Activity, Long Run Decisions, and the Risk Premium in Energy Futures

April 2015 Abstract We present evidence that the aggregate capital stock of firms in oil and gas exploration and development (E&D) as well as firms’ inventories help in explaining the dynamics of the slope of the futures curve for crude oil. Standard structural approaches for modeling the futures curve either highlight the role of inventory (storage models) or the rate of extraction (production models), but both decisions are seldom modeled simultaneously. Here we build a new equilibrium model that has both features, and in addition, models the process of E&D capital accumulation, which can affect the cost of extraction as the oil industry drills in increasingly expensive fields. We show how the three decisions interact in a world of exhaustible resources. In a nutshell, a steeper futures slope not only increases the attractiveness of carrying inventory, but also provides greater value to accumulating E&D capital. Our model sheds light on the role of exhaustibility of resources on the increasing trend of real oil prices and capital accumulation, and the peaking of consumption. Its also helps understand why inventories and E&D capital each negatively predict returns on oil futures, and is thus able to shed light on the negative relation between the slope and risk premium on oil futures.