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Three-factor commodity forward curve model and its joint P and Q dynamics

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Three-factor commodity forward curve model and its joint
P and Q dynamics

Sergiy Ladokhina , Svetlana Borovkovaa,∗

a
Vrije Universiteit Amsterdam

Abstract
In this paper, we propose a new framework for modelling commodity forward
curves. The proposed model describes the dynamics of fundamental driving
factors simultaneously under physical (P ) and risk-neutral (Q) probability
measures.
Our model an extension of the forward curve model by Borovkova and
Geman (2007), into several directions. It is a three-factor model, incorpo-
rating the synthetic spot price, based on liquidly traded futures, stochastic
level of mean reversion and an analogue of the stochastic convenience yield.
We develop an innovative calibration mechanism based on the Kalman
filtering technique and apply it to a large set of Brent oil futures. Addition-
ally, we investigate properties of the time-dependent market price of risk
in oil markets. We apply the proposed modelling framework to derivatives
pricing, risk management and counterparty credit risk. Finally, we outline
a way of adjusting the proposed model to account for negative oil futures
prices observed recently due to coronavirus pandemic.
Keywords: Commodity forward curve, derivatives pricing, oil futures,
joint dynamics model, Kalman filter, Brent oil futures

1. Introduction

1.1. Motivation
Commodities is a popular and continuously growing asset class, inter-
esting not only for commodity producers and consumers, but also for insti-
tutional investors. Commodity derivatives markets exhibit a multi-billion

∗
Corresponding author
Email addresses: sladokhin@gmail.com (Sergiy Ladokhin), s.a.borovkova@vu.nl
(Svetlana Borovkova)

Preprint submitted to Elsevier February 5, 2021

yearly trading volumes. Trading or investing in commodities is, however,
a risky business: due to new technological developments in commodities
production and rapidly changing geopolitical landscape, commodity prices
show extreme moves, high volatility and dynamic correlations with other
asset classes. A quest by academics as well as practitioners for realistic
commodity price models is far from over.
The following recent example shows the potential impact of model risk
on financial institutions involved in commodity markets. On September 10,
2018, a major default had happened on NASDAQ Central Counterparty
(CCP) Clearing [1], [2]. The default of energy trader Einar Aas results in
exhausting of multiple capital buffers in the CCP default waterfall, namely
variation margin, initial margin, default fund contribution, dedicated NAS-
DAQ resources, as well as default fund contribution of other members. In a
way, this resulted in a near default situation for NASDAQ CCP, one of the
major clearing houses in the world. The losses were caused by more than
expected loss in the spread trade in European electricity futures. Although
it is hard to pinpoint exact reasons for the default of Einar Aas’s firm, it
is clear that problems in modelling of energy futures were partly to blame.
This shows how important commodity price models (and especially futures
price models) are for internal risk management of financial institutions as
well as for the stability of financial system as a whole.

1.2. Commodity forward curves

Commodity forward curves - collections of futures prices for a range of
maturities - are fundamental objects that are at the center of commodity
trading and risk management. Futures prices are the result of liquid trading
of a large number of market participants and provide an excellent mechanism
of price discovery. This is particularly true for crude oil futures - the most
liquid futures contracts in the world. Commodity producers and consumers
are exposed to the movements in futures prices more than to movements
in the spot price. Furthermore, futures prices reveal the parameters of the
risk-neutral measure, necessary for pricing commodity derivatives.
Commodity futures prices can demonstrate complex patterns (see Fig-
ure 1 for examples of different shapes of oil forward curves). Crude oil
forward curves can be in the so-called backwardation, when futures that ex-
pire soon are more expensive than those expiring later - something not often
observed in other markets. The opposite situation is called contango. For
seasonal commodities such as gas, electricity or agricultural commodities,
forward curves can exhibit maturity-related seasonal patterns. So modelling
commodity forward curves requires different tools and techniques than e.g.,

2
 78
Market Futures prices Market Futures prices
60

76
74
55
Price (USD)

Price (USD)

72
70
50

68
45

66
0.0 0.5 1.0 1.5 2.0 2.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0

Time to expiry (years) Time to expiry (years)

(a) Brent futures oil curve in contango on 12-11- (b) Brent futures oil curve in backwardation on
2015. 24-07-2018.

Figure 1: Oil forward curves can be in a different shapes, for example contango or back-
wardation, and all the different regimes in between.

simple no-arbitrage (buy-and-hold) arguments, commonly used in futures

pricing for investment assets.
Until recently, everyone assumed that commodity futures (and spot)
prices can only be positive. A well-know exception to this are electricity
prices, which regularly dip into negative territory. This happens due to
market imbalances and oversupply of electricity (for example, due to high
quantity of wind-generated electricity). This, in combination with inability
to store electricity efficiently, can lead to producers being prepared to pay
for someone to take over the excess supply of electricity in order not to
compromise the network. On April 20, 2020, for the first time ever a similar
situation has occurred in oil futures market. The COVID-19 crisis has led to
an unprecedented fall in the global demand for oil, as travel and industrial
production have screeched to a halt. The current demand for oil is 30% less
than in the months before the crisis, while the production cut agreed by
oil-producing countries (OPEC+) is only 10%. This resulted in a huge glut
of crude oil in the world. Crude oil storages were nearly full, and oil tankers
that usually transport oil around the world were floating near harbours fully
loaded. As a result, not only oil prices have fallen but also storage costs have
spiked to levels never seen before: chartering a large oil tanker cost in that
period over 180,000 USD per day (in “normal” circumstances it would cost
approximately 13,000 USD per day), and even at that price there are hardly

3
any empty tankers available.
US oil wass in a particularly tight spot, as it is produced in land-locked
regions and has to be transported via pipelines to the nearest storage facil-
ities or harbours. Added to that is the fact that oil futures contracts in the
US have a particular feature: the owner of such a contract must take physi-
cal delivery of oil once the contract expires. So, if such delivery takes place,
oil must be stored or immediately refined into gasoline and other products.
European futures for Brent oil, which comes from the North sea, do not
have this feature – these contracts are cash settled, by paying or receiving
the difference between the price written in the contract and the current oil
price, so no physical delivery takes place.
So a couple of days before the May WTI contract expired, traders were
faced with a dilemma: to either take physical delivery (which was impossible
due to lack of storage) or to pay in order to not do that. The amount they
were prepared to pay to get out of their contracts was as high as 40 US
dollars per barrel of oil, which was still lower than the astronomic storage
costs they would otherwise have encountered.
This event highlights the need for specific solutions tailored to complexity
of oil (and other commodity) markets, and in this case, variants of models
that would allow for negative futures prices (even though these might be
short-lived). So in this paper we also outline a way of adjusting our proposed
model to deal with this phenomenon.

1.3. Commodity forward curve models

Generally, there are three distinct approaches to model commodity fu-
tures prices. The first approach starts with a stochastic dynamics of the
spot price and, from that, a formula for futures prices is derived as the
expectation of the future spot under the risk neutral probability measure.
Such models are either calibrated to observed history of spot prices (under
the physical probability measure) or fitted to the observed forward curves
(under the risk-neutral probability measure).
The second approach assumes certain dynamics directly of the forward
prices (see e.g., Amin, Ng and Pirrong (1995)). The forward curve is con-
sidered a given object that is formed as a result of trading. This approach is
useful to price derivatives on futures contracts (instead on spot commodity).
Finally, the third approach is to assume a functional relationship between
forward and spot prices. This functional form usually depends on the spot
price as well as on the so-called convenience yield - a rate of return of owning
the commodity rather than a futures contract on it (such approach some-
times also referred to as the cost-of-carry).

4
 It is often assumed that commodity prices exhibit a mean-reverting be-
havior. This behaviour is observed not only in a short-time deviations of the
spot price, but also in a long-term property of the prices to revert to the sta-
ble means over years or even decades. Such behavior of commodity markets
significantly differentiates them from equity markets. For a broad discussion
on mean reverting properties of commodity prices, see an excellent book by
[3].
The standard mean-reversion process assumes that the stochastic vari-
able (e.g., a commodity spot price) reverts to the constant mean. To date
however, little attention was given to the stationarity of this mean. Em-
pirical evidence suggests that the mean level of commodity prices is not
constant but stochastic with a (relatively) low volatility. This has deeper
economic justification, e.g., the relationship of commodities to business cy-
cles, extraction and production technologies and other varying economic
fundamentals. So forcing the mean level to be constant (while it is not)
leads to instability and poor performance of models. The first step towards
stochastically varying mean in mean reversion models for commodities has
been set by [4], who showed that models that allow for slowly varying mean
fit market prices better than the standard mean-reversion. In this paper,
we will further develop this approach.
Commodity markets are influenced by multiple economic forces that have
different impacts on the spot price and forward curves. This results in a
complex stochastic behaviour that cannot be fully described by one-factor
models. A popular stochastic two-factor model is that of Schwartz-Smith [5].
This model assumes the first factor to be a zero-mean Ornstein-Uhlenbeck
process and it represents short term fluctuations of price. The second, long-
term factor is modelled by the arithmetic Brownian Motion. The two factors
are assumed to be correlated. The Schwartz-Smith model provides a close
formula for futures prices and suggests an effective calibration method. How-
ever, often two factors are still not enough to create a flexible model that
fits market quotes well, and an additional factor(s) is needed. Here we will
add one more factor to a two-factor model and will simultaneously describe
long-term behavior as well as medium and short term price fluctuations.
A major drawback of many commodity forward curve models is their
reliance on the spot price. In practice, often the spot price is not directly
observable; moreover,it is usually determined in a relatively illiquid OTC
market. Borovkova and Geman (2007) introduced an alternative approach
to overcome the issue of unobservable spot price. As the main driving fac-
tor, they use a synthetic spot price which is a geometric average of observ-
able futures prices (this has an analogy with some futures-based oil price

5
benchmarks). By construction, this synthetic spot price is non-seasonal, not
prone to jumps and exhibits lower volatility than the actual spot price (if
such is observed at all). The Borovkova-Geman model also incorporates the
convenience yield and deterministic seasonal premium. However, the model
describes the dynamics of the forward curves only under the real-world prob-
ability measure. This makes it useful for risk management applications, but
not for derivatives pricing. An extension of this model, presented here,
overcomes calibration difficulties under both real world and risk neutral
probability measures.

1.4. Model summary and goals of the paper

The main aim of this paper is two-fold: to expand the Borovkova-Geman
commodity forward curve model to include stochastically varying price level
and to develop its calibration to the risk-neutral probability measure, which
allows for derivatives pricing. This results in the so-called joint-measure
model. Such a model simultaneously describes the dynamics under real-
world and risk-neutral probability measures. As a side research question,
we investigate the dynamics of market price of risk under assumptions of
our model. Our extended model is a useful practical tool for pricing and
risk management of commodity derivatives.

The general modeling framework presented here has three fundamental

factors:

• Synthetic spot price. This factor was originally introduced in the

work of Borovkova and Geman; it corresponds to the level of the com-
modity forward curve. This factor is based on the actual quotes of
the (liquid) futures, so it better reflects overall price level compared to
the (often non-transparent) spot price. Moreover, the synthetic-spot
factor is not seasonal and does not exhibit jumps.

• Long-run stochastic mean. This is the major innovative element of

the model: we assume that the synthetic spot price is mean-reverting,
but in contrast to the previously proposed models, it reverts to the
slow-varying (and stochastic) mean. This echoes concerns of practi-
tioners, who believe that over time commodity prices return to some
”psychological” expected mean level, but that this level is not con-
stant.

• Short-term deviation factor, or convenience yield. This factor

corresponds to the well-known concept of convenience yield. This fac-

6
 tor is modeled by zero-mean mean-reverting process. Loosely speak-
ing, it is driven by those economic factors that change the near-end of
the forward curve, such as changes in the inventory levels.
We develop an innovative way to calibrate our model under two prob-
ability measures, by a variant of Kalman filtering technique. We fit the
model parameters to the extensive history of Brent oil futures curves. The
model shows good fit to the market prices across all maturities, as well as
consistent factors’ dynamics.
A side research question discussed in this paper is a time-dependent
market price of risk. The market price of risk links the dynamics of the
asset under physical and risk-neutral probability measures. Typically it is
assumed to be constant. Inspired by the work of Willmot and Ahmad [6], we
propose a way to estimate time-dependent market price of risk. We apply
it to the historical market price of risk for Brent oil futures.
The proposed model has multiple practical applications, such as deriva-
tives pricing, market risk management, as well as counterparty credit risk
and credit valuation adjustments. These applications are extremely impor-
tant for many financial institutions, so we discuss them in detail at the end
of the paper.
The remainder of the paper is organized as follows. We start with the
short overview of popular forward curve models in Section (2). In Section
(3), we introduce the synthetic spot price and other building blocks of our
model. In addition, this section also contains derivations for the commodity
futures prices and their dynamics. This section is the key section of the
article. In Section (5.1), we describe the state-space representation of the
model which allows for the application of Kalman filter. In Section (5),
the calibration set-up and results are described. Model applications are
summarized in Section (6). Finally, we state possible future extensions of
the model in Section (7).
Note that we use the terms ‘futures’ and ‘forwards’ interchangeably, to
mean financial contracts that allow to buy or sell a certain amount of a
spot commodity in the future. Such interchangeability is justified since we
focus on the commodity price dynamics and largely ignore interest rates,
transaction costs and counterparty risk. As a result, the terms ’futures
curve’ and ’forward curve’ are also used interchangeably.

2. Overview of related forward curve models

The topic of energy futures modelling is not new in academic literature.
The early models were based on the considerations for equity or interest

7
rate derivatives. Such approaches did not result in successful models and
the need for specialized energy models was recognized.

2.1. Mean-reverting model

It is often stated that energy (and other commodity) prices exhibit mean-
reverting pattern. The early models incorporate mean-reversion in the com-
modity spot price. They were fundamentally one-factor models, so the spot
price was the single stochastic factor driving evolution of forward curves,
such as in the Schwartz one-factor model, see [7] for details. The model
describes the dynamics of the underlying spot price as:

dS(t) = κ(µ − ln S(t))S(t)dt + σS(t)dW (t), (1)

where µ is a constant mean reversion level, κ speed of mean-reversion, σ is

volatility of the spot price and W is the standard Brownian motion. This
model is very similar to the famous Vasicek interest rate model, with log-spot
replacing the short-rate dynamics.
Recall that, in mathematical terms, the commodity’s futures price is
equal to the risk-neutral expectation of the commodity spot price S(T ):

F (t, T ) = EQ [ST |Ft ], (2)

where Ft is filtration on date t.

By explicitly computing EQ [ST |Ft ], the mean reverting model is analyt-
ically tractable and provides explicit formulas for forward curves as well as
for European options. However, this model is unrealistic for several reasons.
It has only one stochastic factor which is not sufficient to explain all vari-
ability in the forward curve’s shape. Although the volatility of futures prices
is, as expected, decreasing function of time to maturity, it goes to zero for
long maturities, which is empirically not observed. Finally, the model relies
on constant mean µ. Such mean is hard to calibrate, as it can change signif-
icantly over time. In our model, the mean reversion level will be stochastic
(but slowly varying), introducing a lot more flexibility in traditional mean
reverting models.

2.2. Schwartz-Smith two-factor model

Energy prices are impacted by multiple economic events, such as changes
in supply-demand, inventory levels, news, political events, technological de-
velopments, and so on. This suggests a need for multiple factors to describe
the forward curve dynamic. A popular choice is the two-factor forward curve

8
model by Schwartz and Smith, introduced in [5]. The model describes the
spot price as a sum of two (not directly observable) factors:

ln St = χt + ξt . (3)

The dynamics of the factors is described by the following stochastic differ-

ential equations:
dχt = −κχt dt + σχ dW1 ,
(4)
dξt = µdt + σξ dW2 ,
where W1 and W2 are two correlated Brownian motions. The forward curve
is obtained by introducing market price of risk and finding the expectation
of the spot price under the risk neutral probability measure. Here we will
use a similar technique to go from physical to risk-neutral probability mea-
sure. We extend the ideas behind Schwartz-Smith model by introducing an
observable factor and increasing the total number of model factors to three.

2.3. Gibson-Schwartz stochastic convenience yield model

Gibson-Schwartz model [8] is yet another example of a two factor model.
The model describes dynamics of underlying spot price St and the stochastic
convenience yield δt . The dynamics of the state variables is given by the
following processes:

dSt = (r − δt )St dt + σS St dWS ,

(5)
dδt = [κ(α − δt ) − λ]dt + σδ dWδ ,

where WS and Wδ are two correlated Brownian motions. The Gibson-

Schwartz model, as Schwartz-Smith model, results in a closed form formula
for futures prices.

2.4. Spot-forward relationship

The spot price S(t) and the forward (or futures) prices F (t, T ) are linked
by the well-known cost-of-carry relationship:

F (t, T ) = S(t)e(r−y)(T −t) , (6)

where we assume that the spot price S(t) is observable, r is the constant
interest rate, y is the so-called convenience yield, which is often defined
by the above relationship. The convenience yield is the rate of return, or a
”premium” of owning the physical commodity rather than a futures contract.

9
The above relationship stems from no-arbitrage arguments for ”storable”
commodities. We refer to [3] for details.
Although frequently used by practitioners, the spot-forward relationship
is more a transformation from the observed forward curve F (t, T ) (and the
interest rate r) to the unobserved convenience yield y(t). To use the cost of
carry relationship, we need a model for the convenience yield y(t). The con-
venience yield that follows from the forward-spot relationship is not constant
for different maturities, moreover it dynamically changes over time.
Furthermore, in this approach, the forward prices are directly based on
the spot price S(t), which can be unreliable and often even unobserved. In
many energy markets, the spot price S(t) is determined by a small group
of physical commodity traders in a nontransparent way. In many cases,
the spot price is quoted, instead of being determined as a result of actual
trading. This is different from futures market, where settlement prices of
futures contracts F (t, T ) are determined based on actual trading.

2.5. Borovkova-Geman model

One way to overcome problems with an unreliable spot price (or its
absence) was introduced by Borovkova and Geman in [9]. Their model is
build around an observable factor F̄ (t). This factor, the average futures
price, is non-seasonal, directly observable, and is explicitly computed from
liquid futures quotes F (t, T ) as their geometric average (possibly liquidity-
weighted). In their model, the forward prices are given by the following
formula:

F (t, T ) = F̄ (t)e(s(T )−y(t,T −t))(T −t) , (7)

where s(T ) is a seasonal premium and y(t, T −t) is a mean-reverting dynamic
convenience yield. Such model can be applied for both non-seasonal and
seasonal commodities such as natural gas and electricity. As the model de-
scribes the forward curve dynamics under the physical probability measure,
it is useful for simulations (under that measure) and for risk-management
purposes, but it cannot be directly used to price derivatives. One of the
goals of our work is to extend the concept of synthetic spot factor F̄ (t) to
be used as a main building block for forward curve dynamics not only under
physical, but also under risk neutral probability measure.
These are just a few models in a long list of forward curve models
suggested in the literature. Other models worth mentioning are: Trolle-
Schwartz model with stochastic volatility [10], Geman-Roncoroni model [11],
Geman model [12].

10
3. Model definition and specification
3.1. Synthetic spot factor
We start describing our model by introducing an observable factor which
reflects the actual liquid trading; even for seasonal commodities, this factor
is non-seasonal. This is what we call the ”level” factor. Such factor should
be not influenced by tilts, or contango-backwardation transitions of the for-
ward curve. Denote the futures price of a commodity on date t as F (t, T ),
where T is the expiry date. Time to expiry of the futures contract is given
by T − t. Denote the commodity spot price as St (if it is observed).

Similar to [9], let us introduce synthetic spot factor F̄ (t), which is defined
as: v
u n
uY
n
F̄ (t) = t F (t, Ti ), (8)
i=1

where n = nt is the number of all (liquid) available futures traded on day t.

Synthetic spot price is a non-seasonal characteristic of the forward curve, cor-
responding to its level. Due to averaging, this factor evolves quite smoothly
over time - it typically does not exhibit jumps and has lower volatility than
e.g., spot price or first nearby futures price. Since synthetic spot is a func-
tion of (liquid) futures prices, it is based on active trading (in contrast to
the spot price St , which is quoted by a small pool of commodity produc-
ers). In a way, replacing St by F̄ (t) as the main building block of the model
prevents the same problems as in interest rate markets with LIBOR-style
rates1 . We will work with the logarithmic representation of the synthetic
spot factor: Xt ≡ ln F̄ (t). A comparison between the synthetic spot factor
and the actual spot is given in Figure 2. As can be seen from that figure,
the synthetic spot factor corresponds to the level of the curve (given by the
geometric average of futures prices). Note that this average will, in general,
deviate from the actual spot price St . This deviation is determined by the
slope of the forward curve: if the curve is in contango (as shown in Figure
2), the synthetic spot is above the actual spot, and in backwardation this
is reversed. This motivates us to introduce the second fundamental factor,
which will be similar to the convenience yield (as it is that factor that de-
termines whether the curve is in contango or backwardation) and which we

1
In interest rate markets, many derivatives were quoted based on unreliable and non-
transparent LIBOR rates that did not reflect actual market trading - something that
impending LIBOR reform aims to rectify.

11
 56

4.05
Market futures prices Log−prices of futures
Synthetic spot level Log−synthetic spot level Xt
Spot level Log−spot level
54

Spot price Log−spot price lnSt

4.00
52

3.95
Price (USD)

Log−price
50

3.90
48

Xt

3.85
yt
46

lnSt

3.80
44

0.0 0.5 1.0 1.5 2.0 2.5 3.0 0.0 0.5 1.0 1.5 2.0 2.5 3.0

Time to expiry (years) Time to expiry (years)

(a) In price terms (b) In log-price terms

Figure 2: A schematic representation of the synthetic spot compared to the actual spot
level.

denote by yt . This factor will reflect deviations between the actual spot
price St and its synthetic version F̄ (t).

3.2. Three factor model

The three fundamental factors in our model are:

• Synthetic log-spot Xt , introduced above. This factor corresponds to

the level of the forward curve, it is non-seasonal and it is based on
actual trading in liquid futures.

• Analogue of the convenience yield yt . The need for this factor comes
from the fact that synthetic spot F̄ (t) is not equal to the actual spot
price St . Short term deviations between synthetic and actual spot will
be driven by this factor. It is influenced by changes in supply-demand
balance, inventory level or news.

• Long-term average commodity price Lt . This fundamental factor cap-

tures the long-term price development. This factor is influenced by
long term supply-demand expectations as well as by the speed of tech-
nological advances in energy production. Arguably, this factor is slow
varying, with the volatility much smaller compared to the volatility of

12
 synthetic spot factor Xt . This factor is the key innovative element of
the proposed model.

The actual spot price is represented as the sum of the synthetic spot and
the convenience yield (deviation between the actual and synthetic spots):

ln St = Xt + yt . (9)

Many commodities also exhibit seasonal effects. In that case, the above
equation can be extended by adding a deterministic seasonal component,
which can be easily estimated from historical price series. Since this pa-
per focuses on non-seasonal commodities such as crude oil, we will leave
modelling seasonality effects to a subsequent paper.
We can rewrite the model in the following, perhaps more intuitive way.
Assume that the long-term mean of the (log) oil price (i.e., of synthetic log
spot Xt ) is Lt - this is the mean reversion mean of Xt , but which is not
constant (instead, we can model it as e.g., a stochastic process with a very
low volatility). Define a new factor

ψt ≡ Xt − Lt .

This factor corresponds to the deviations of the synthetic log-spot Xt from

its long-term mean Lt . Such deviations are usually triggered by longer term
changes in supply-demand balance or political events.
With this new factor at hand, the spot representation (9) can be re-
written into the following three factor model:

eq10 ln St = ψt + yt + Lt , (10)

(since ψt = Xt − Lt ). Such spot representation is similar to the one in

Schwartz-Smith model [5], but has a different interpretation and dynamics
of factors.
To summarize: Lt is the long-term factor, influenced by long term market
developments; ψt is the ”medium-term” factor, it changes faster than Lt and
it is influenced by medium-term events, and yt is the ”short-term” factor,
influenced by short term changes in supply and demand or fluctuations in
inventories.

3.3. Dynamics of factors

Recall that both factors ψt and yt are essentially deviations of something
from something else, so it is reasonable to assume that both follow the

13
ordinary mean-zero Ornstein-Uhlenbeck process. The long-term mean Lt is
fundamentally a macroeconomic variable, indicating long-term stance of the
oil price. So in agreement with academic literature, the dynamic of Lt is
often assumed to be a random walk. This is what we will assume here also.
Let P be the physical probability measure. We postulate the following
factor dynamics under the physical probability measure P:

dψt = −αψt dt + σdW1 ,

dyt = −ayt dt + ηdW2 , (11)
dLt = σL dW3 ,

where Wi are (possibly correlated) Brownian motions. We assume these

Brownian motions to have the following correlation structure: dW1 dW2 = ρ,
dW1 dW3 = 0 and dW2 dW3 = 0. In principle, we could let all correlations
to be non-zero, but we restrict two of them to be zero for simplicity and
due to some economic intuition: the moves at the short end of the forward
curve (i.e., of short maturities’ futures prices) are typically in sync with the
synthetic spot price. The long-term price level is impacted by quite different
market forces than the short- or mid-end of the forward curve, hence the
corresponding correlations are assumed to be zero. In addition, we define
σL = qσ, with 0 < q < qmax < 1. The idea behind such representation is to
ensure that the volatility of long-term price is smaller than the volatility of
the synthetic log-spot factor Xt . Similar to the signal processing literature,
we call parameter q the signal-to-noise ratio.

In the above model, Lt is the long-run mean of the stochastic log-spot

price Xt but it is itself also stochastic. The idea behind this factor is to
model long-term shared view, or expectation of market participant about the
”level of crude oil prices”. Such level incorporates political developments,
economic cycles, ongoing technological advances (e.g., shale oil, under ice
exploration, tar sands) as well as global changes in the demand for oil (e.g.,
electrification, wider availability of alternative energy). Stochastic mean is
a much slower changing quantity compared to the other model factors; this
property is enforced by setting q < 1 (and typically q << 1). The slow
varying long term mean model for commodity products was also introduced
by Borovkova et al. in [4].

In contrast to Lt , the factor yt corresponds to the short term deviations

of the stochastic spot Xt from the actual log-spot price ln St . Movements
in yt result from short term supply and demand changes, weather impact,

14
news and such factors. As with the traditional convenience yield, it is nat-
urally to assume that yt is a mean-reverting process with zero mean: short
term changes in supply or demand will have an influence on short-term (i.e.,
spot) commodity price, but once resolved, it is expected that the spot price
will go back to the ”overall” level. Finally, ψt is a mean-reverting spread
between the synthetic spot price Xt and its long-term mean Lt .

In general, oil prices are more sensitive to the supply-demand changes

and less to the interest rate or inflation. Moreover, usually inflation is con-
sidered as a result of an increase in oil price and not other way around
(see for example [13]). That is the reason for not including interest rate or
inflation-specific factors into the model.

3.4. Model variant for negative futures prices

When, in April 2020, WTI futures prices went negative, many financial
institutions had big problems with their models and software. A typical
”duct tape” solution was to simply ignore the offending futures contract
(the first nearby one) and base all the calculations of the remaining futures
prices, which remained positive. However, this is clearly not a sustainable
solution in the long term. Here we would like to suggest such a solution,
within the framework of our model.
First of all, in calculation of our first fundamental factor F̄ (t), we in-
clude only those futures prices that are positive. This is not a significant
restriction, since negative prices in oil markets will be short-lived and are
not representative of the overall state of the oil market (this is in contrast to
negative interest rates, which can remain negative for a very long period of
time, truly depicting the state of the money markets, as we observe at the
moment of writing of this paper). The definition of X(t) remains the same,
as the logarithm of F̄ (t).
Another modification of our model allowing it to deal with negative
prices is in Equation (??), where we replace logarithm of spot price by the
spot price itself:
St = ψt + yt + Lt . (12)
The dynamics of all fundamental factors remains the same. So we are basi-
cally going from logarithmic to arithmetic representation of the model. In
this representation, spot as well as nearby futures prices can become nega-
tive. In our subsequent paper we will further develop this model variant and
apply it to WTI futures. But here we proceed with the logarithmic form of
the model and its application to Brent futures prices.

15
3.5. Risk neutral dynamics
To derive the formula for futures prices, we need to compute the expec-
tations of the spot price under the risk neutral measure. Before that, we
present the dynamics of the factors under this risk neutral measure. Overall,
our approach is similar to the one used by Schwartz and Smith in [5], where
the dynamics under physical measure is adjusted by the market price of risk.

Let us introduce the equivalent martingale risk-neutral probability mea-

sure Q. This measure is connected with the physical probability measure
P by means of the arket price of risk λ. The model dynamic under the
risk-neutral measure is then:

dψt = −αψt dt − λσdt + σ dWg1 ,

dyt = −ayt dt − ληdt + η dW

g2 , (13)
dLt = −λσL dt + σL dW
g3 ,

where W fi are Q-Brownian motions with the same correlation structure as

Wi . By the above representation we explicitly assume that there exist a sin-
gle market price of risk parameter that is used in the dynamics of all of the
factors. We choose to subtract λ while some authors add it in risk-neutral
dynamics. Note, that conceptually this is equivalent and the only difference
is that the sign of the calibrated parameter λ. The quantities λσ, λη and
λσL are also called risk premia. Our representation explicitly assumes that
the risk premia are proportional to the volatility of each of the factors. An
alternative approach would be to assume a different market price of risk
parameter (say λ1 , λ2 , λ3 ) for each source of risk. However, we will not con-
sider such approach in this paper. Under our assumption, investors consider
risk premium to be proportional to the volatility of the risk source, and the
proportionality constant is the same of all risk sources.

For now we assume that the market price of risk λ is constant, although
later on we will relax this assumption. We will introduce a time depen-
dent market price of risk λt and suggest a way to estimate it from the
data. Although our estimation approach will differ from the one proposed
by Wilmott and Ahmad in [6], we obtain a similar interpretation of results.
Note that the dynamics of yt can be rewritten in terms of uncorrelated
Brownian motions:
p
g1 + η 1 − ρ2 dW
dyt = −ayt dt − ληdt + ηρdW g4 , (14)

16
where dW
g1 , dWg2 and dW g4 are pair-wise uncorrelated. We will use this
representation in further steps of the model building.

4. Forward curve and its dynamics

4.1. Forward price

We can now proceed to deriving formula for forward prices. In line
with literature, the forward price is the expectation of the spot price under
the risk-neutral probability measure Q. The model dynamics allows us to
solve for this expectation. Processes ψ and yt are described by Orstein-
Uhlenbeck process and Lt is described by arithmetic Brownian motion. Such
representation allows us obtain log-spot price at time T , given Ft :
λσ λη
ψT + yT + LT = ψt e−α(T −t) − (1 − e−α(T −t) ) + yt e−at − (1 − e−a(T −t) )
α a
Z T Z T
−α(T −t) αs f −a(T −t)
+Lt − λσL (T − t) + σe e dW1 (s) + ηρe eas dW
f1 (s)+
t t
p Z T Z T
η 1 − ρ2 e−a(T −t) eas dW
f4 (s) + σL eαs dW
f3 (s).
t t

The above solution allows us to explicitly compute the expected value EQ [ψT +
yT + LT |Ft ] and the variance of V arQ [ψT + yT + LT |Ft ] of the log-spot price:

E[ln ST |Ft ] = ψt e−α(T −t) + yt e−a(T −t) + Lt −

hη σ i
λ (1 − e−a(T −t) ) + σL (T − t) + (1 − e−α(T −t) ) ,
a α

σ2 2σηρ
V ar[ln ST |Ft ] = (1 − e−2α(T −t) ) + (1 − e−(α+a)(T −t) )+
2α (α + a)
ρ2 η 2 η 2 (1 − ρ2 )
(1 − e−2a(T −t) ) + (1 − e−2a(T −t) ) + σL (T − t).
2a 2a
Since ln ST is normally distributed, the spot price is log-normally distributed
with mean:
h i h i 1 h i

EQ ψT +yT +LT |Ft = exp EQ ψT +yT +LT |Ft + V arQ ψT +yT +LT |Ft .
2
The above results allow us to formulate the following proposition.

17
Proposition 1. Forward price of a commodity, where spot price is repre-
sented by the 3 factors following the dynamics (13), is given by:

F (t, T ) = EQ [ST |F] = exp ψt e−α(T −t) + yt e−a(T −t) + Lt + A(t, T ) , (15)

where
σ η
A(t, T ) = −λ (1 − e−α(T −t) ) + (1 − e−a(T −t) ) + σL (T − t) +

α a
σ 2 σηρ
(1 − e−2α(T −t) ) + (1 − e−(α+a)(T −t) )+
4α (α + a)
ρ2 η 2 η 2 (1 − ρ2 ) σL
(1 − e−2a(T −t) ) + (1 − e−2a(T −t) ) + (T − t).
4a 4a 2
The above formula provides the futures price at time t (so also at t = 0)
for maturity T . This price depends on the current value of the three state
variables ψt , yt and Lt as well as on the parameters of their dynamics.

A natural requirement for a forward price is the condition that, for a

short time-to-expiry, forward price would converge to the spot price. It is
easy to see that, when T = t, the forward price formula above will indeed
simplify to the spot price and will be ST ≡ F (T, T ) = eψT +yT +LT . We will
illustrate this later on empirical data.
If the arithmetic version the model is used, the derivations in this and
following paragraphs simplify significantly, as we only need to deal with
a simple sum of Brownian Motions. So here we will proceed with a more
involved, geometric version of the model, and leave the corresponding deriva-
tions of futures prices and their dynamics to a future research.

4.2. Futures price dynamics

For many applications, such as derivatives pricing, we need the dynamics
(and especially the volatility) of the futures price. Moreover, we must impose
a natural condition that the futures prices are martingales under Q.
Here we derive, by Ito’s lemma, the dynamics of the futures price dF (t, T ),
which depends on three stochastic variables ψt , yt , Lt .
Proposition 2. THe dynamics of the forward price of commodity, whose
spot price follows the 3 factor model with dynamics (13) is given by:
dF (t, T )
= (σe−α(T −t) + ηρe−a(T −t) )dW
g1 +
F (t, T ) (16)
p
η 1 − ρ2 e−a(T −t) dW
g4 + σL dWg3 .

18
 Time dependent volatility of futures

0.50
0.45
0.40
Volatility

0.35
0.30
0.25
0.20

0 2 4 6 8 10

Years to maturity

Figure 3: Volatility term structure. The shape is consistent with patterns observed in
implied volatility of futures options on futures, the so-called ]it Samuelson effect.

The resulting process has zero drift, so is a martingale. This is in line with
our expectation about the form of the forward price dynamics. From this
dynamics we can easily obtain the time- and maturity-dependent Black’s
volatility:
q
σB (t, T ) = (σe−α(T −t) + ηρe−a(T −t) )2 + η 2 (1 − ρ2 )e−2a(T −t) + σL2 . (17)

This volatility can be directly used in Black-76 formula to price options on

futures. An example of the volatility term structure is given in Figure 3. As
can be seen in the picture, the volatility decreases with the time to maturity;
for long maturities it will converge to non-zero σL . This property overcomes
existing problems with many simple mean-reverting models, where volatility
decreases to zero for long maturities.

Inspired by yield curve modelling, commodity forward curve modelling

can follow two main approaches. First one assumes, as a starting point, the
dynamics of the spot (or short rate), while another one assumes directly the
dynamics of the forward prices (or instantaneous interest rate forwards).
The second approach is also referred to as Heath–Jarrow–Morton (HJM)
framework. In this paper, we have chosen for the first approach, with the
goal to obtain a closed form formula for futures prices. Formula (16) is
an important link between our approach and the HJM-style framework in
commodity forward curve modelling. Equipped with this formula, we can

19
extend the modelling considerations outlined in this paper to pricing of
exotic derivatives on both commodity spot and futures contracts.

5. Calibration

5.1. State-space representation

By design, our model is a joint-dynamics model. This term was intro-
duced by Hull, White, Sokol in [14] in the context of interest rate models.
The parameters of such a model describe dynamics under both physical and
risk-neutral probability measures. Such approach poses some challenges to
the calibration of the model: the calibrated model should fit observed mar-
ket prices of derivatives (futures) and at the same time produce parameters
that evolve from one day to another according to the specified dynamics.
A suitable approach to solve such problems is filtering approach, known
from the field of signal processing. We estimate the model with a dynamic
panel data set of futures prices via Kalman filter combined with the method
of maximum likelihood. In order to apply Kalman filtering technique, the
state-space representation of the problem has to be written first. The state-
space representation consists of the measurement and transition equations.
First, we formulate the measurement equation for the model (10) (geometric
version of the model):
  −α(T1 −t)
e−a(T1 −t) 1  
   
ln F (t, T1 ) e A(t, T1 )
 ln F (t, T2 )   e−α(T2 −t) e−a(T2 −t) 1  ψt  A(t, T2 ) 
     

 ... =
  ... ... ...  yt  + 

 ...  +t , (18)

ln F (t, TN ) e−α(TN −t) e−a(TN −t) 1  Lt A(t, TN )
ln(F̄ (t)) 1 0 1 0

with [ψt yt Lt ]T being a state vector. t is an N + 1 vector of disturbances

with E[t ] = 0 and V ar[t ] = Ht , where matrix Ht is a diagonal matrix with
elements equal to ht . The last row of the measurement equation is a way to
enforce the condition that the filtered value of the synthetic spot is equal to
the observed value: Xt = ln F̄ (t).
Transition equation describes the dynamics of the state vector and is given
by:     
ψt 1 − α∆t 0 0 ψt-1
 yt  =  0 1 − a∆t 0  yt-1  + wt (19)
Lt 0 0 1 Lt-1

20
In the above equation, wt is a residual vector with zero expected value
E[wt ] = 0 and the variance given by:
 2 
σ ∆t σηρ∆t 0
V ar[wt ] = σηρ∆t η 2 ∆t 0 .
0 0 2
σL ∆t

Note that, for our application, ∆t corresponds to daily changes and is equal
to 1/365 or 1/250, depending on whether calendar or trading days are con-
sidered.

The explicit representation of the problem in terms of measurement and

transition equations allows us to apply Kalman filter machinery, including
explicit formula for the log-likelihood of residuals. In this work we will not
give further overview of the approach and will refer to [15] instead.

The Kalman filtering approach allows us to calibrate the model simulta-

neously under the physical P and the risk-neutral Q probability measures.
From a practical perspective, it means that the single model can be used for
risk management applications (under P) as well as for pricing applications
(under Q). Using the single model for these two purposes can significantly
reduce model risk as well as costs (of development and validation) in a finan-
cial institution. Moreover, such an approach can result in a more consistent
modelling practices between departments within one financial institution.

5.2. Data
We apply our model to an extensive dataset of ICE Brent futures prices.
Brent oil is the major oil benchmark and one of the most heavily traded oil
grades in the world with many derivatives using it as the underlying. We use
Brent futures for a period from 7-02-2005 till 24-07-2018. Note that Brent
futures have not become negative in 2020 as WTI futures did. So in our
next paper, we will apply the model to WTI futures, including most recent
negative prices.
There are 3134 daily observations of the Brent oil forward curves in our
dataset. Brent contracts have a monthly expiration schedule, but for each
day we use first 6, 9-th, 12-th, 18-th, 24-th, 30-th and 36-th to expiry futures
contract. That results in a daily observations of 12 points which form the
forward curve. Such choice is guided by higher trading volumes of the front
futures compared to the low liquid far end of the curve. In addition, to

21
 Parameter Value (Standard Error)
λ 0.1443254∗∗∗ (0.009361403)
α 0.2430296∗∗∗ (0.001635522)
σ 0.4000135∗∗∗ (0.003455691)
a 3.7857089∗∗∗ (0.024889426)
η 0.003885854∗∗∗ (0.003885854)
ρ 0.5457884∗∗∗ (0.027449226)
q 0.5246947∗∗∗ (0.010475912)

Table 1: Calibration results with qMax = 0.9.This results are obtained after 10000 itera-
tions of the first step of the solver, 56 iterations of the second step of the solver and result
in log-likelihood of 159280.

reflect liquidity of the contracts, we have used the first 6 contracts on a

daily calculation of F̄ (t).

5.3. Calibration approach and results

The model is calibrated by minimizing negative log-likelihood function
of THE Kalman filter. The optimization is performed on a changed (un-
bounded) variables, which are then converted back to the original (bounded)
variables for likelihood computations. This is done to ensure number of
conditions (such as positive volatility and mean-reversion speed). The op-
timization is performed in two steps. On the first step, the global solver is
applied (we have used simulated annealing algorithm) to determine a region
with the global minimum. This algorithm is applied with arbitrary chosen
values of the input parameters. On the second step, a local solver is used
with the starting values of parameters obtained on the first step. We use
a Quasi-Newton method with numerical estimation of derivatives as a local
solver. Such two-stage approach allows to avoid local minima associated
with parameters that are unrealistic close to their bounds.

The calibration procedure takes as an input prices of futures F (t, T1 ),

F (t, T2 ), ..., F (t, TN ), history of synthetic spot factor F̄ (t), value of qMax as
well as a set of initial values for model parameters θ0 , where θ0 =< λ0 , α0 ,
σ0 , ρ0 , η, q, ψ0 , y0 , L0 >. We design the calibration in such way that the
following constrains are satisfied: α > 0, a > 0, σ > 0,η > 0, 0 < q < qMax ,
−1 < ρ < 1, ln 30 < L0 < ln 100.
In addition, we also calculate two error measures to compute the goodness

22
of fit of theoretical forward curves vs observed ones:
v
u
u 1 N X K
X
2
AbsoluteRM SE = t FMarket (tj , Ti ) − FModel (tj , Ti ) ,
N +K
i=1 j=1
v
N X K 
FMarket (tj , Ti ) − FModel (tj , Ti ) 2
u 
u 1 X
RelativeRM SE = t ,
N +K FModel (tj , Ti )
i=1 j=1

where K = 3469 is the total number of daily observations in the dataset.

We have used R statistical software for all of the computations. The

optimal parameters calibrated with fixing qMax = 0.9 are presented in Ta-
ble 1. The calibration procedure depends on qMax as an input parameter.
Natural question could be a sensitivity of the model to the choice of qMax .
The sensitivity of the model calibration to the choice of qMax parameter is
summarized in Table 2. The run with qMax = 0.9 results in the best market
fit as well as in the highest value of the likelihood function. The run with
qMax = 0.1 gives attractable model features, such as low volatility of the
long-term factor Lt ; as well as still acceptable quality of the model fit. We
choose to use these two settings, the particular value of the qMax depends
on the potential model use. For each application considered in this paper
we will specify the value of qMax used. In addition, Table 2 contains the
values of Absolute and Relative RMSE assuming constant market price of
risk (MPR).

The filtered time series of the state variables are presented in Figure 4.
As can be seen in these figures, volatility of the short-term deviation factor
yt is smaller compared to the volatility of ψt - this is inline with our model
specification. Moreover, we see that stochastic log mean Lt is varying, but
stays in a relatively smaller range compared to the changes of synthetic
spot factor Xt . This is also in line with empirical observations, that energy
prices mean-revert, but not to the constant, but to some kind of floating
level. In addition, in Figure 5 we show that the sum of the filtered time
series Lt + ψt is very close to the observed synthetic spot time series Xt .
This is an additional confirmation of correctness of our model. Finally, an
example of the fit of the theoretical model (qMax = 0.9) to the market data
is given in Figure 9. As can be seen from this figure, the model fits observed
market prices of futures very well.

23
 Parameter Test 1 Test 2 Test 3 Test 4
qMax 0.9 0.5 0.25 0.1
λ 0.1443254 0.1152516 0.0952823 0.13578620
α 0.2430296 0.2427340 0.2406266 0.23215921
σ 0.4000135 0.4000178 0.4512142 0.49656735
a 3.7857089 3.7472506 3.8200394 3.82370828
η 0.1187412 0.1183404 0.1036434 0.10015373
ρ 0.5457884 0.5413630 0.2817274 0.11572452
q 0.5246947 0.4866871 0.2499994 0.09999984
Log-likelihood 159280.0 159263.1 158507.9 154705.2
Num. Iterations (step 1) 10000 10000 10000 10000
Num. Iterations (step 2) 56 64 120 144
Absolute RMSE 0.3085206 0.409216 0.3377983 0.4753287
Relative RMSE 0.004492449 0.005627727 0.004748221 0.006187431

Table 2: Sensitivity of model calibration results to the choice of qMax parameter.

Model factor ψt Model factor Lt

Model factor yt Model factor Xt = Lt + ψt
5.0
0.5

4.5
Factor value

Factor value
0.0

4.0
−0.5

3.5
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Date Date

(a) ψt and yt (b) Lt and Xt

Figure 4: Filtered time series of model factors. Signal-to-noise ratio of q = 0.1.

24
 Difference of observed Xt vs. filtered (Lt + ψt)

0.02
0.01
Residuals value

0.00
−0.01
−0.02
−0.03

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018
Date

Figure 5: Differences between filtered time series of Lt + ψt and observed synthetic spot
time series of Xt . Signal-to-noise ratio of q = 0.1.
80

Market Futures prices

Model prices with constant λ
70
Price (USD)

60
50
40

0.0 0.5 1.0 1.5 2.0 2.5 3.0

Time to expiry (years)

Figure 6: An example of the model fit to Brent futures market data on 29-12-2008. The
boundary of signal-to-noise ratio is qMax = 0.9.

25
 0.30

0.05
Difference between spot and model implied spot eψt+yt+Lt Difference between synthetic F and model implied spot eψt+yt+Lt
0.25
0.20

0.00
Difference in percent

Difference in percent
0.15

−0.05
0.10
0.05

−0.10
0.00
−0.05

−0.15
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018
Date Date

(a) Differences between observed Brent spot price (b) Differences between the synthetic spot price
and model-implied spot price St = eψt +yt +Lt . F̄ and model-implied spot price St = eψt +yt +Lt .

Figure 7: Differences between model-implied spot St = eψt +yt +Lt , observed Brent spot
price and synthetic spot F̄ . Signal-to-noise ratio of q = 0.1.

5.4. Model-implied spot price

One of the main distinctive features of our model is the synthetic spot
factor Xt . This factor is determined using only futures prices and not the
actual spot price. However, our model can be used to determine the model-
implied spot price St = eψt +yt +Lt . Such a spot price depends on the liquid
derivatives products and reflects significant trading volumes, rather than a
small panel of large market players. The time series of differences between
the model-implied spot price and the actual Brent spot price is given in
Figure 7. This figure shows that the model-implied spot follows the actual
spot price remarkably well, as the differences are generally less than 5 cents
per barrel (with the exception of one observation).

When financial press talks about ”the oil price”, they can mean different
things. As the ”state” of oil market is given by the combination of the
current spot price and the today’s forward curve, different reference prices
can be chosen as ”the oil price”. Typically, it is the price of the first-to-
expire futures contract, but sometimes (but rarely) it is the oil spot price.
Our model suggests two more candidates for such a reference price: the
synthetic spot price F̄t and the model-implied spot price St = eψt +yt +Lt .
The problem with the first nearby futures contract is that it does not
represent the ”constant maturity” object, because its time to expiry changes

26
every day (i.e., it decreases by one day). Both synthetic spot F̄t and the
model-implied spot price are synthetic objects without an expiry date. This
is a convenient feature for the modelling purposes.
While the implied spot price is model-dependent (it depends not only
on the underlying processes, but also on the choice of calibration method),
the synthetic spot F̄t is model-independent. It also has an advantage that
it reflects liquid and traded contracts. Finally, the synthetic spot Xt has
lower volatility than the nearby futures price, observed and model-implied
spot prices. In all, it provides a great alternative (to the first nearby futures
price or spot price) commodity ”reference price”.

5.5. Stochastic market price of risk

The model specified in (13) contains a constant parameter for the market
price of risk λ (MPR). As was argued in [6], MPR parameter is actually time-
dependent, moreover, it is most likely stochastic. We can expend our model
to accommodate for the time-dependent market price of risk. This is done
by changing the specification of the Kalman filter and introducing one more
unobservable variable λt . This is possible because the pricing formula for
futures can be re-written as follows:
−α(T −t) +y −a(T −t) +L +λ B(t,T )+C(t,T )
F (t, T ) = eψt e te t t
, (20)

where in case of a constant MPR A(t, T ) = λB(t, T ) + C(t, T ). The specifi-

cation of the measurement equation of the Kalman filter changes too:
  −α(T1 −t)
e−a(T1 −t) 1 B(t, T1 )  
   
ln F (t, T1 ) e C(t, T1 )
 ln F (t, T2 )   e−α(T2 −t) e−a(T2 −t) 1 B(t, T2 )  t ψ
  yt   C(t, T2 ) 
 
  
 ... = ... ... ... ...    
   +  ...  + t ,
ln F (t, TN ) e−α(TN −t) e−a(TN −t) 1 B(t, TN ) Lt
   
C(t, TN )
λt
ln(F̄ (t)) 1 0 1 0 0

The transition equation then becomes:

    
ψt 1 − α∆t 0 0 0 ψt-1
 yt  
 = 0 1 − a∆t 0 0  yt-1  + wt ,
 
Lt   0 0 1 0 Lt-1 
 
λt 0 0 0 1 λt-1

27
 Test type Absolute RMSE Relative RMSE
Constant MPR 0.3085206 0.004492449
Time dependent MPR 0.2113817 0.003041120

Table 3: Quality of fit of theoretical forward curve to market quotes with time dependent
MPR λt and the boundary of signal-to-noise ratio qM ax = 0.9.

Where wt is a residual vector with zero expected value E[wt ] = 0 and the
variance given by:
 2 
σ ∆t σηρ∆t 0 0
σηρ∆t η 2 ∆t 0 0 
V ar[wt ] = 
 0 2
.
0 σL ∆t 0 
0 0 0 σλ2 ∆t

We apply a similar two-steps optimization procedure to determine optimal

parameters of the new filter. For this test, we keep the boundary of signal-
to-noise ratio at qM ax = 0.9. The resulting filtered time series of λt for
Brent oil is presented in Figure 8. As can be seen from the picture, MPR
increases during the times of price increase, and drops during the periods
of the market stress. These findings are similar to the ones observed in
the interest rate markets in [6]. Willmott defines the periods of low (or
even negative) market price of risk as periods of ”fear”, while high positive
values of MPR would correspond to the periods of ”greed”. Finally, the
model with time dependent MPR λt results in a lower RMSE and ARMSE
measures (see Table 3 for details).

5.6. Comparison to Gibson-Schwartz model and out-of-sample performance

In this section we describe model benchmarking tests, where we com-
pare the performance of our 3-factor model to the performance of Gibson-
Schwartz model (see section 5.6 for details). Gibson-Schwartz model is a
very popular choice among practitioners, so it is natural to choose it as the
comparison. We perform two performance comparisons tests: in-sample and
out-of-sample. For the in-sample test, we fit both models on the whole Brent
futures data set described in section 5.2 and calculate errors within the same
data set. For the the out-of sample comparison, we first calibrate the mod-
els on the data from 07-02-2005 to 29-12-2017, then we filter unobserved
variables for dates from 02-01-2018 to 24-07-2018. Finally, we calculate the
errors on trading dates from 02-01-2018 to 24-07-2018. In such a way, the

28
 Constant MPR λ
Filtered MPR λt
0.4

GREED
0.3
Market price of risk

0.2
0.1
0.0

FEAR
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018
Date

Figure 8: Time-dependent market price of risk λt for Brent oil futures.

80

Market Futures prices

Model prices with constant λ
Model prices with filtered λt
70
Price (USD)

60
50
40

0.0 0.5 1.0 1.5 2.0 2.5 3.0

Time to expiry (years)

Figure 9: An example of the model fit with time-dependent MPR λt to Brent futures
market data on 29-12-2008.

29
 Test type Model Absolute RMSE Relative RMSE
In-sample Gibson-Schwartz 0.4477562 0.006629341
In-sample Proposed model 0.3085206 0.004492449
Out-of-sample Gibson-Schwartz 0.2521213 0.005555177
Out-of-sample Proposed model 0.3369156 0.005278424

Table 4: Comparison of quality of fit of the proposed model to Gibson-Schwartz model.

differences between market and model prices are evaluated on the data dif-
ferent from the one used for model calibration.

For the benchmarking tests, we have used R implementation of the

Gibson-Schwartz model provided by package Schwartz97 (refer to package
documentation [16] and [17] for more details). Gibson-Schwartz model was
calibrated using functionality of Schwartz97 package; calibrated parameters
are described in Appendix A.5.

For the comparisons tests we have used a calibration version of our 3-

factor model with qM ax = 0.9. This setting results in the highest value of the
likelihood function and lowest RMSE. The results of model benchmarking
for in-sample and out-of-sample performance are given in Table 4.

Our 3-factor model performs superior to Gibson-Schwartz model for in-

sample comparison test. It also performs with a comparable error for out-
of-sample test. The proposed model has an advantage of a number of pre-
defined features (such as synthetic spot price, long-run mean) that give our
model a more intuitive interpretation without the loss of a good fit to the
observed futures prices.

6. Model applications

6.1. Scenario generation

Our three-factor model has multiple practical applications. In this sec-
tion, we discuss some of them. One natural application of the model is
forward curve scenario generation. For example, for counterparty credit
risk (CCR) computations, one would consider long-horizon simulations un-
der the risk neutral probability measure. Such computations can be used as

30
a part of the CVA engine, where one computes potential negative and posi-
tive counterparty exposures of a commodity derivatives book. The general
approach for implementing such exposure model is:

• Calibrate model parameters (including the market price of risk λ),

based on historical observations of forward curves. Typically a few
years of historical data is used, possibly including a period of market
stress if required by the regulation.

• Using model dynamics under risk-neutral probability Q, generate sce-

narios of the state variables ψt , yt and Lt . This is done by generating
a number of paths up to some required time horizon. Typically, 5000
to 10000 paths are generated.

• Based on the generated scenarios of the state variables, calculate sce-

narios of commodity forward curves using formula (15).

• For each curve scenario, re-price all the derivatives associated with
this curve. This will result in the risk-neutral distribution of portfolio
values for a given counterparty at a given future time.

• Based on the scenarios of portfolio values, calculate statistics of inter-

est such as Expected Positive Exposure, Expected Negative Exposure
or other.

A visual example of Monte-Carlo simulations under the risk-neutral proba-

bility measure is shown in Figure 10.

Another possible application of the model is for market risk manage-

ment purposes. Here one would generate forward curve scenarios with a
short horizon (typically 2-10 days) and the simulations should be based on
the physical probability measure. This is done in a similar way as above,
but using the equation (11) and by computing different risk metrics (such as
Value at Risk or Expected Shortfall), based on the generated set of scenar-
ios. Such applications can be especially valuable for initial margin modelling
for clearing houses and brokers.

6.2. Pricing options on calendar spread futures

Our model can be used also for pricing commodity derivatives. The
model naturally yields close formula solutions for futures and forwards con-
tracts. In this section we discuss possible application of the model to pricing

31
 Filtered path of spot eψt + yt + Lt
Simulated pathes of spot price
Forward curves scenarios

150
Price (USD)

100
50

2018 2019 2020

Date

Figure 10: Example of Monte-Carlo simulations using the three factor synthetic spot
model. Simulation start on 2018-07-11 and the simulation end date is 2019-07-11. Such
simulations allow practitioners to compute exposures on 2019-07-11.

of a more complex derivative products, namely options on calendar spreads.

The payoff of a calendar spread is the difference between two futures

with different expiry dates R(t, T1 , T2 ) = F (t, T2 ) − F (t, T1 ). A typical ex-
ample is the calendar spread between the second and the first nearby futures.
Calendar spreads can be used, for example, to hedge against the move of
the commodity curve from contango to backwardation and vice verse. A
European option on a calendar spread is an option whose payoff depends on
the value of the spread R(texp , T1 , T2 ) at the option’s expiry date texp ≤ T1 .

Calendar spread options can be viewed as a particular case of a more

general construction - basket or spread options. Calendar spread consists of
the futures from the same forward curve, while general basket and spread
options can contain different commodity futures. A typical example is 3:2:1
crack spread which is a difference between different quantities of crude oil,
heating oil and unleaded gasoline.

The main challenge in pricing of basket options lies in the fact that a
linear combination of log-normally distributed random variables is not log-

32
normally distributed. Moreover, it does not follow any known probability
distribution. As the result, the Balck-Scholes framework for pricing op-
tions cannot be applied. Borovkova, Permana and Weide [18] proposed a
robust way to price basket options based on displaced log-normal distribu-
tion. The approach approximates the distribution of the basket value based
on the moment matching technique. The paper describes close-form pricing
formulas for options on very general baskets and so also on calendar spreads.
The framework in [18] depends on the following assumptions about futures
dynamics:
dFi (t, Ti )
= σi dW̄i (t), i = 1, 2, ..., N (21)
Fi (t, Ti )
where σi2 is a variance of the futures i, N is a number of assets in the basket,
W̄i (t) and W̄j (t) are Brownian motions driving futures i and j with corre-
lation ρ̄i,j .

The same framework can be applied to the problem of pricing European

option on calendar spreads. Moreover, it can be combined with the proposed
3-factor model. To do that, we need to determine the variances of the futures
in the spread and the correlation coefficient. This can be done by re-writing
the dynamics of the futures F (t, T1 ) and F (t, T2 ) from the representation
(16). The correlation between two futures is naturally given as the ratio of
covariance to the variances of the corresponding legs of the spread:
Cov1,2
ρ̄1,2 = √ . (22)
V ar1 V ar2
The covariance can be calculated from the dynamics of the forward prices
16 and is given by the following formula:

Cov1,2 = σ 2 e−α(T1 +T2 −2t) + ηρσe−α(T1 −t)−a(T2 −t) + ηρσe−a(T1 −t)−α(T2 −t) +
η 2 ρ2 e−a(T1 +T2 −2t) + η 2 (1 − ρ2 )e−a(T1 +T2 −2t) + σL2 .
(23)
The variance for futures F (t, Ti ) is:

V ari ≡ σi2 = (σ 2 e−α(Ti −t) + ηρe−a(Ti −t) )2 + η 2 (1 − ρ2 )e−2a(Ti −t) + σL2 . (24)

The above formulas depend on the calibrated model parameters. The corre-
lation coefficient (22) depends on the time difference between the legs of the
spread T2 − T1 . The dependency of the correlation to the value of T2 − T1
is presented in Figure 11. As can be seen from that figure, the correlation
decreases when time spread increases. Overall, correlation stays high which

33
 1.00
Correlation ρ1,2

0.95
Correlation

0.90
0.85
0.80

0 1 2 3 4 5

Time difference T2−T1

Figure 11: Correlation between two legs of calendar spread F1 and F2 represented as a
function of difference between corresponding time to expiry of the futures T2 − T1 . The
time to expiry of the first future is fixed at 10 days T1 = 10/365.

is consistent with empirical observation that two futures prices with nearby
time to expiry are highly correlated.
Plugging in equations (23) and (24), which result from the dynamics of
our 3-factor model into a robust framework proposed in [18], we are able to
price calendar spread options in a fast and efficient way.

7. Concluding remarks and further research

In this paper we proposed a new three-factor model to describe the dy-

namics of the commodity (energy) forward curves. The new model is an
example of the so-called ”joint dynamics” model: i.e., the model that de-
scribes dynamics of the state variables under both risk-neutral and physical
probability measures.
The model is based on the three factors with the synthetic spot factor
being the main one. The synthetic spot factor was originally introduced by
Borovkova and Geman in [9] and has a number of useful properties. Our
work extends the work in [9] in three dimensions:
• It specifies the model not only under the physical, but also under the
risk-neutral probability measure.
• It adds a stochastic but slowly varying long-term mean to the mean
reverting dynamics of the commodity price.

34
 • We develop an innovative calibration approach based on the Kalman
filtering methodology.
Furthermore, we outlined possible model adjustments for dealing with
recently observed negative futures prices.
We also demonstrated that the market price of risk plays an important
role in transition from P to Q measure, and that the market price of risk is
not constant, but stochastic and is related to the price level. This is in line
with findings of Willmot and Ahmad in [6].
We described practical applications of the model, ranging from scenario
generation (under physical or risk-neutral probability measures) to pricing
options on calendar spreads.
Future research will be focused on including stochastic volatility and
seasonal effects into the model, as well as applying the arithmetic version of
the model to WTI futures which recently exhibited negative values.

References

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[2] Nasdaq-Clearing, Clearing member default that occurred 10 september,

2018 (2018).
URL https://business.nasdaq.com/
updates-on-the-Nasdaq-Clearing-Member-Default/index.html

[3] H. Geman, Commodities and commodity derivatives. Modelling and

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Ltd., 2005.

[4] S. Borovkova, H. Bunk, W. Gooeij, D. Mechev, D. Veldhuizen, Collater-

ized commodity obligations, Journal of Alternative Investments 16 (2)
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namics in Commodity Prices., Management Science 46 (7) (2000)
893–911.

[6] R. Ahmad, P. Wilmott, The market price of interest-rate risk: Mea-

suring and modelling fear and greed in the fixed-income markets,
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 [7] E. Schwartz, The Stochastic Behavior of Commodity Prices: Impli-
cations for Valuation and Hedging., Journal of Finance 52 (3) (1997)
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[8] G. R., S. E. S., Stochastic Convenience Yield and the Pricing of Oil
Contingent Claims., Journal of Finance 45 (1990) 959–976.

[9] S. Borovkova, H. Geman, Seasonal and stochastic effects in commodity

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[10] A. B. Trolle, E. S. Schwartz, Unspanned stochastic volatility and the

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[11] H. Geman, A. Roncoroni, Understanding the fine structure of electricity

prices., Journal of Business 79 (3) (2006) 1225–1261.

[12] H. Geman, Scarcity and Price Volatility in Oil Markets., EDF Trading
Technical Report (2000).

[13] M. LeBlanc, M. D. Chinn, Do high oil prices presage inflation? the

evidence from g-5 countries, UC Santa Cruz Economics Working Paper
No. 561 (2004).
URL https://ssrn.com/abstract=509262orhttp://dx.doi.org/
10.2139/ssrn.509262

[14] J. C. Hull, A. Sokol, A. White, Modeling the short rate: The real
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[15] J. Durbin, S. J. Koopman, Time Series Analysis by State Space Meth-

ods (Oxford Statistical Science Series Book 38), 2nd Edition, OUP
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[17] D. Luthi, P. Erb, S. Otziger, Schwartz 1997 two-factor model technical

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the valuation and hedging of basket and spread option, The Journal of
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URL https://jod.iijournals.com/content/14/4/8

36
Appendix A. Appendices

Appendix A.1. Derivation of forward pricing formula

In this section we will derive forward contracts pricing formula (15). As
was mentioned before the log-spot is assumed to depend on three stochastic
factors ln ST = ψT + yT + LT . The dynamics of these factors under the
risk-neutral probability measure is given by equation (13).
The dynamics of ψT is described by Orstein-Uilenbeck process, which results
in the following solution is:
Z T
−α(T −t) λσ
ψT = ψt e − (1 − e−α(T −t) ) + σe−α(T −t) eαs dW
f1 (s).
α t

The dynamics of yT can be solved in a similar way leading to:

Z T
λη
yT = yt e−a(T −t) − (1 − e−a(T −t) ) + ηρe−at eas dW
f1 (s)+
a t
p Z T
−a(T −t)
η 1−ρ e 2 eas dW
f4 (s).
t

Finally, the dynamics of the long-run mean LT is described by arithmetic

Brownian motion, which also enables us to easily obtain the solution:
Z T
LT = Lt − λσL (T − t) + σL eαs dW
f3 (s).
t

The next step is to compute expected value and variance of log-spot process
ln ST . These calculations are based on the fact that all three stochastic
factors are normally distributed. The expected part is easily obtained from
the above solutions of SDE:

E[ln ST |Ft ] = ψt e−α(T −t) + yt e−a(T −t) + Lt

hη σ i
−λ (1 − e−a(T − t)) + σL (T − t) + (1 − e−α(T −t) ) .
a α
The variance of log-spot is given by the sum of variances with respect to
individual uncorrelated Brownian motions:

V ar[ln ST |Ft ] = V1 + V2 + V3 ,

37
where
Z T  2
V1 = σe−α(T −t) eαs + ηρe−a(T −t) eas ds =
t
Z T  2
σ 2 e−2α(s−(T −t)) + 2ηρσe(a+α)(s−(T −t)) + η 2 ρ2 e2a(s−(T −t)) ds =
t
σ2 2σηρ η 2 ρ2
(1 − e−2α(T −t) ) + (1 − e−(a+α)(T −t) ) + (1 − e−2a(T −t) ),
2α α+a 2a

V2 = σL2 (T − t)

η 2 (1 − ρ2 )
V3 = (1 − e−2a(T −t) ).
2a
Finally, since all the stochastic factors are normally distributed, the log-
spot price is also normally distributed. As the consequence, spot price is
log-normally distributed. The forward price is equal to the expected value
of the spot price, which yields the following pricing formula:
−α(T −t) +y −a(T −t) +L +A(t,T )
F (t, T ) = EQ [ST |F] = eψt e te t
,

where
σ η
(1 − e−α(T −t) ) + (1 − e−a(T −t) ) + σL (T − t) + +

A(t, T ) = −λ
α a
σ2 σηρ
(1 − e−2α(T −t) ) + (1 − e−(α+a)(T −t) )+
4α (α + a)
ρ2 η 2 η 2 (1 − ρ2 ) σL
(1 − e−2a(T −t) ) + (1 − e−2a(T −t) ) + (T − t).
4a 4a 2
Appendix A.2. Derivation of forward dynamics
In this section we will derive dynamics of the forward price and we will
do it in two steps. First, we will compute partial derivatives of log-forward

38
price G(t, T ) ≡ ln F (t, T ) with respect to the stochastic factors and time:

∂G ∂G
= F (t, T )e−α(T −t) , = F (t, T )e−a(T −t) ,
∂ψ ∂y
∂G ∂2G
= F (t, T ), = F (t, T )e−2α(T −t) ,
∂L ∂ψ 2
∂2G −2a(T −t) ∂2G
= F (t, T )e , = F (t, T ),
∂y 2 ∂L2
∂G ληa −a(T −t)
= F (t, T ) αψt e−α(T −t) + ayt e−a(T −t) +

e
∂t a
λσα −α(T −t) 2ασ 2 −2α(T −t)
+σL λ + e − e −
α 4α
σηρ(α + a) −(α+a)(T −t)
e −
(α + a)
η 2 ρ2 2a −2a(T −t) σL2 η 2 (1 − ρ2 )2a −2a(T −t) 
e − − e .
4a 2 4a
After applying Ito’s lemma and cancelling some terms, we will obtain:

dF (t, T ) p
= (σe−α(T −t) + ηρe−a(T −t) )dW
f1 + η 1 − ρ2 e−a(T −t) dW
f4 + σL dW
f3 .
F (t, T )

Appendix A.3. Change of variables in optimization

The model calibration is performed in terms of changed variables θei ,
this is done to ensure realistic constrains on the optimal parameters values
(such as positive volatility). There are few types of variable change used
in the model. The model is defined in terms of bounded variables θi , but
the optimization routines (both global and local) are defined in terms of
unbounded variables θei . We will list the types of variable constrains and the
corresponding transformation functions:

• For θi > 0 the following transformation is used:

θi = eθi + c,
e

θei = ln(θi − c),

where c = 1e − 08 is a small positive constant. This transformation is

used for mean-reversion coefficients and volatilitites that are not part
of covariance matrix (such as σL ).

39
 Parameter Value
α 0.7926642222
σ 0.3999862774
a 1.8170002163
η 0.1007189394
ρ 0.1552717310
q 0.8334227542
σλ 0.1012842194

Table A.5: Calibration results for time-dependent MPR test with qMax = 0.9.This results
are obtained after 10000 iterations of the first step of the solver, 116 iterations of the
second step of the solver and result in log-likelihood of 175684.7.

• For correlation/covariance matrix a special transformation is applied.

This is done to ensure three things: that volatilitities are positive,
that correlations are within [−1, 1] and that the covariance matrix is
positive semidefinite. This is achieved by performing optimization in
terms of coefficients of Cholesky matrix decomposition a11 , a12 , a22 ,
where c < aij < 104 . The covariance matrix R is obtained as AAT ,
where A is a lower diagonal matrix with coefficients aij . Volatilities
sigma and eta as well as correlation ρ can be easily derived from
covariance matrix R.
• For −cMin ≤ θi ≤ cMax the following transformation is used:
cMax − cMin cMax + cMin
θi = arctan(θei ) + ,
π 2
cMax + cMin
π

θei = tan θi − ,
2 (cMax − cMin )
where cMax and cMin are two constants that bound the variable θi .
This transformation is used for bounded variables, such as L0 , q, as
well as for a11 , a12 , a22 etc.

Appendix A.4. Optimal permeates time-dependent MPR test

Optimal parameters for Kalman filter with time-dependent MPR λt are
presented in Table A.5.

Appendix A.5. Parameters of Gibson-Schwartz model

Optimal parameters for Gibson-Schwartz model used for model bench-
marking are presented in A.6.

40
 Parameter All data set From 07-02-2005 till 29-12-2017
α 0.4177644 0.595662
σS 0.537943 0.6050017
κ 0.5190225 0.5142756
σδ 0.2471361 0.2530181
ρ 0.8656749 0.9071371
λ 0.2623438 0.3732789

Table A.6: Calibrated values of Gibson-Schwartz model that are used for the model bench-
marking. The interest rate r is taken as an average USD Fed-Fund rate over the dates
within the data set and is equal to r = 0.0134.

41

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