Scarcity Risk Premium & Liquidity Provision in Commodity Markets

Thibault Lair, PhD
Commodities, theory of storage, seasonality, scarcity, risk premium, inventories, underreaction, market anomalies, factors, liquidity provision, speculators, hedging pressure.

Abstract :

Scarcity Risk Premium: This paper revisits the cost-of-carry model and proposes a decomposition of the futures basis that disentangles the seasonality risk premium from the scarcity risk premium. The contribution of this paper to the asset pricing literature is threefold. First, it brings novel insights on the fundamental relationship between the futures basis and inventory dynamics. Empirical evidence shows that theseasonality risk premium captures expectations about the inventory seasonalities while the scarcity risk premium reflects the excess supply and demand imbalances over the expected seasonal fluctuations. Second, this papers investigates the pricing of expectations within the futures basis. Results suggest that the seasonality risk premium is priced-in and that the scarcity risk premium carries all the predictive power embedded in the futures basis. The third contribution of this paper is to provide evidence that the scarcity risk premium, and ultimately the futures basis, is mostly a compensation for the unexpected increase in the risk of stock-out and that the associated return predictability finds its origin in the slow diffusion of information and underreaction to abnormal changes in inventories, above and beyond seasonal dynamics.

Liquidity provision in commodity markets: Beyond the net hedging demand:  The contribution of this paper to the literature on the hedging pressure and liquidity provision in commodity markets is threefold. First, it exploits a largelyvunder-researched dataset to identify the presence of pure liquidity providers, beyondvhedgers and speculators, and their key role in facilitating market clearing. Second, to understand the risk associated with the provision of liquidity, this paper documents the presence of factor premia in the cross-section of calendar spreads and the materiality of transaction costs for the survival of pure liquidity providers. Finally, it revisits the price impact of market participants and the risk premium sharing across those. Pure liquidity providers break even, before accounting for the potential bid-ask spread capture, and help in mitigating the price impact of other traders, which is found to be economically but not statistically significant. Producers cost of hedging exhibits high sensitivity to trading frictions, the relative size of hedgers and speculators, as well as to factor exposures.

Publication date of the thesis

Thesis committee

Supervisor: Frank Fabozzi, formely EDHEC Business School 

External reviewer: K. Geert Rouwenhorst, Yale School of Management 

Other committee member: Nikolaos Tessaromatis, EDHEC Business School