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

Abstract

Investment by oil firms positively affects the futures basis and negatively predicts excess returns on crude oil futures. I build an equilibrium model of drilling, exploration, and storage to understand these facts. Firms' capital stock lowers extraction costs as firms drill in increasingly expensive fields. Drilled wells produce the resource at a geometrically declining rate; however, by specifying consumers' habit level equaling production from old wells, the futures basis and risk premium are only related to drilling, investment, and inventory. Investment leads to a more elastic drilling response by firms and dampens oil price increases from demand shocks, thus lowering the risk premium.

Keywords: Futures basis; risk premium; social learning-by-doing; inventory; investment; exploration;

JEL Classification: G12, G13, Q31, Q32, Q41, Q43