Basis Variation and the Role of Inventories: Evidence from the Crude Oil Market
Understanding the variation in the spread between the futures price and the spot price (known as the basis) is important for efficient hedging and for explaining the dynamics of commodity spot prices. Classical studies based on the theory of storage explain the variation in the basis in terms of changes in the fundamentals of supply and demand and/or storage technology of the underlying commodity (Kaldor, 1939; Working, 1948; Brennan, 1958; and Telser, 1958). Other studies explain the variation in the basis in terms of time-varying risk premiums which are influenced by preferences and beliefs of participants in the futures markets (Bailey and Chan, 1993). While the basis is relatively stable when compared to the variability of spot or futures prices, it may exhibit large variability for some commodities and may follow different dynamics depending on the behaviour of stocks of the underlying commodity.