Uncertainty and the Price for Crude Oil Reserves

September 1996 Returns to storage for crude oil reserves contain both a cost-reducing component (consistent with Kaldor's original notion of convenience) and often sizable premiums associated with the dispersion of petroleum prices. Innovations in futures, options, and derivative instruments permit active trading, speculating, and hedging - linking markets for physical petroleum products with financial markets. These derivative markets continuously value petroleum delivered today and for future dates, thus providing a market price for inventories. Underground petroleum reserves are also an inventory defined by exploration surveys and development drilling. As a result, observable market information can be used to value these reserves. Option-valuation models can be used to price reserves using observable markets, but are dependent on unexplained convenience yields revealed by the term structure of futures prices. Considine and Larson apply a general model of inventory pricing to petroleum inventories and generate an empirical model of the returns to storage for petroleum markets. They examine the determinants of the convenience yield for crude oil using a stochastic control model. They specify optimal production and inventory conditions using a third-order cost function and estimate them using monthly observations. Their inventory arbitrage condition embodies the Hotelling principle and Kaldor's convenience yield, and includes a premium on the dispersion in crude oil prices. The empirical results suggest that returns to storage contain both a cost-reducing component (consistent with Kaldor's original notion of convenience) and often sizable premiums associated with the dispersion of petroleum prices. Their findings suggest that crude oil markets differentiated by quality and location provide similar premiums. The premiums associated with the dispersion of ...