Convenience yield in commodity price modeling: A regime switching approach

- Using regime switching modelling, we allow for two equilibrium levels the convenience yield process reverts to
- Futures price is derived and parameters are estimated for crude oil and natural gas markets
- One regime is found to have high convenience yield and high volatility while the other is found to have low convenience yield and low volatility
- Estimated regimes correspond very closely to contango and backwardation
- Transitional probabilities are found to dictate the shape of the far end of the futures term structure

This paper attempts to model the futures term structures of crude oil and natural gas using the notion of convenience yield in a regime switching framework. Unlike the existing studies, which assume the convenience yield to have either a constant value or to have a stochastic behavior with mean reversion to one equilibrium level, the model of this paper extends the Gibson and Schwartz (1990) model to allow for regime switching in the convenience yield along with the other parameters. A closed form solution for the futures price is derived and the model parameters are estimated using the maximum likelihood method. The results show that the estimated regimes are very close to the contango and backwardation regimes commonly seen in futures markets. The results also show that the transitional probabilities play an important role in shaping the futures term structure implied by the model.