An Equilibrium Model for Commodity Prices with Regime Switching Reserve Dynamics

Abstract

We explore the implications for asset prices and implied volatilities in an equilibrium model of commodity production. Production of the commodity can be carried out in one of two regimes. In the first regime the reserves are set in constant decline while in the second regime new additions to the reserve base are made. The optimal production rule is to switch regime when the stochastic revenue process of the producer hits certain barrier values. As a consequence of the optimal production rule equilibrium spot prices also become regime switching. The shapes of forward curves and implied volatilities are strongly dependent on the level of the stochastic revenue process.

Keywords: Equilibrium, Commodity, Optimal switching

JEL Classification: Q30, Q40, G11, G13, M11, C61, C41, C44