Production, storage, and futures hedging under uncertainty

Erwin Nijsse
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Erwin Nijsse: Groningen University

No 01E10, Research Report from University of Groningen, Research Institute SOM (Systems, Organisations and Management)

Abstract: This paper provides an integrative survey of literature on commodity futures markets, on storage and production decisions, and on joint spot and futures price formation under uncertainty. The paper focuses on the risk reallocation role of futures markets. Basic models of futures trading by a competitive, risk-averse firm are enhanced with production and storage decisions in a static and dynamic setting. Through inventories and futures hedging both risk premia and an endogenous convenience yield play a role in the firm’s optimisation process. We thus provide a microeconomic foundation for the complementary relationship between the theory of normal backwardation and the theory of supply of storage. Because most futures users operate in an incomplete market setting, special attention is paid to the interaction of production, storage, and hedging determinants, the existence of risk premia and opportunities for diversification of portfolios.

Date: 2001
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