Futures risk premia and price dynamics in energy industry

We examine futures risk premia, and price dynamics in the electric power and natural gas sectors of the US energy industry. First, we use Pennsylvania-Jersey-Maryland electricity pool spot and futures prices to make assessments on spot and futures price dynamics, and futures risk premia. Rather than calculating the mean returns of a particular futures contract as a proxy for the risk premium, we measure the difference between the risk-neutral and actual expected value of the future spot price for all available maturities. The former is the observed term structure of futures prices and the latter is generated by imposing an exogenous process for the spot price of electricity that captures fundemental characteristics of the electricity market such as mean-reversion, seasonality, and jumps. Excluding the recent trends in the US energy market from the data, estimation with standard and Kalman filtering techniques provide us evidence of negative risk premium. An important implication of negative risk premium is that forward prices are upward biased predictors of expected future spot prices. This is consistent with the notion that hedgers, who are long the futures and seek immunization from adverse market conditions, pay insurance premium to speculators, who demand reward for their participation in the futures market.; We then turn our attention to natural gas market and conjecture that limited participation of hedgers in the futures market, which stems from consumers' subsistence needs, results in a non-zero risk premium (to draw speculators into the market) which is correlated to the storage levels. We find that impact of storage levels on the risk premium is partially explained by the link between hedging pressure and risk premium, which has been established in the previous literature, and that inventories still has explanatory power after controlling for the hedging pressure effect.