Oil prices — Brownian motion or mean reversion? A study using a one year ahead density forecast criterion

• Published in: Energy economics Vol. 32; no. 6; pp. 1485 - 1498
• Main Author: Meade, Nigel
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.11.2010; Elsevier; Elsevier Science Ltd
• Series: Energy Economics
• Subjects: Accuracy; Applied sciences; Arbitrage; Brownian motion; Commodity prices; Criteria; Crude oil prices; Density; Density forecasting; Economic data; Energy; Energy economics; Exact sciences and technology; Financing; Forecasts; Fossil fuels and derived products; Futures market; GARCH models; General, economic and professional studies; Investment; Markets; Mathematical models; Methodology. Modelling; Model testing; Oil; Oil market; Oil price; Pricing; Reversion; Stochastic models; Studies; Time series; Time series Density forecasting Commodity prices; U.S.A; Uncertainty; United States > US; USA, Texas; C53; Density forecasting; C22; Commodity prices; G10; Time series
• ISSN: 0140-9883; 1873-6181
• DOI: 10.1016/j.eneco.2010.07.010

For oil related investment appraisal, an accurate description of the evolving uncertainty in the oil price is essential. For example, when using real option theory to value an investment, a density function for the future price of oil is central to the option valuation. The literature on oil pricing offers two views. The arbitrage pricing theory literature for oil suggests geometric Brownian motion and mean reversion models. Empirically driven literature suggests ARMA–GARCH models. In addition to reflecting the volatility of the market, the density function of future prices should also incorporate the uncertainty due to price jumps, a common occurrence in the oil market. In this study, the accuracy of density forecasts for up to a year ahead is the major criterion for a comparison of a range of models of oil price behaviour, both those proposed in the literature and following from data analysis. The Kullbach Leibler information criterion is used to measure the accuracy of density forecasts. Using two crude oil price series, Brent and West Texas Intermediate (WTI) representing the US market, we demonstrate that accurate density forecasts are achievable for up to nearly two years ahead using a mixture of two Gaussians innovation processes with GARCH and no mean reversion.