Energy Economics 45 (2014) 229–233

Contents lists available at ScienceDirect

Energy Economics
journal homepage: www.elsevier.com/locate/eneco

Price discovery in energy markets

Keshab Shrestha 1
Monash University Malaysia, Jalan Lagoon Selatan, 47500 Bandar Sunway, Selangor Darul Ehsan, Malaysia

a r t i c l e i n f o a b s t r a c t

Article history: In this study, we empirically analyze the price discovery process in the futures and spot markets for crude oil,
Received 30 July 2013 heating oil and natural gas using daily closing prices. We use two different information share measures that
Received in revised form 26 May 2014 are based on the methods proposed by Gonzalo and Granger (1995) and Lien and Shrestha (2014). Both
Accepted 6 June 2014
measures indicate that almost all the price discovery takes place in the futures markets for the heating oil and
Available online 22 July 2014
natural gas. However, for the crude oil, the price discovery takes place both in the futures and spot markets. As
JEL classification:
a whole, our study indicates that futures markets play an important role in the price discovery process.
C5 © 2014 Elsevier B.V. All rights reserved.
G14

Keywords:
Unit root
Cointegration
Price discovery
Energy futures

1. Introduction
It is well recognized that futures markets perform two central roles.
Firstly, they provide instruments which can be used to hedge price risk.
Secondly, they are supposed to be the markets where price discovery
takes place. Nainar (1993) analyzes heating oil, heavy oil and regular
gasoline spot prices and finds evidence that the spot market informa-
tion increases with the futures trading of various petroleum derivatives.
This study provides evidence of the price discovery role played by the
futures markets. Price discovery in energy markets is a significant area
of research in the field of Energy Economics. This is evident from numer-
ous published studies (e.g., Bopp and Sitzer, 1987; Bopp and Lady, 1991;
Quan, 1992; Schwarz and Szakmary, 1994; Serletis, 1994; Silvapulle and
Moosa, 1999; Lin and Tamvakis, 2001; Bekiros and Diks, 2008; Serletis
and Rangel-Ruiz, 2004; Huang et al., 2009; Kaufmann and Ullman,
2009; Lee and Zeng, 2011 and Silvério and Szklo, 2012). The reason
for this is because prices, in a free market economy, play an important
role in guiding the allocation of resources to their optimal levels.
As Silvapulle and Moosa (1999) point out, there are theoretical
reasons for the price discovery to take place in the futures market. For ex-
ample, the futures price responds to new information faster than the spot
price due to lower transaction costs and ease of short selling associated
with the futures contracts. Therefore, we expect individuals with private
or superior information to trade in the futures market to benefit from
such information. Also, speculators prefer to hold futures contracts
E-mail address: keshab.shrestha@monash.edu.
1
Monash University Malaysia.
because they are not interested in the physical commodities per se and
find it easy to offset futures positions. Finally, hedgers with storage con-
straints will also buy futures contracts.
Garbade and Silber (1983) develop a model to measure the price
discovery and introduce the concept of dominant and satellite markets
where the dominant market is the place where the price discovery
primarily takes place. Using a vector autoregressive (VAR) model, they
also suggest a method of measuring the price discovery. Garbade and
Silber (1983) empirically analyze the price discovery for wheat, corn,
oats, orange juice, copper, gold and silver. They find empirical evidence
that the price discovery mainly takes place in the futures markets.
Bopp and Sitzer (1987) use cost pass through regression, polynomial
distributed lag model and some forecasting models to analyze monthly
data on heating oil and find that 1-month futures price contains signif-
icant information about the cash price. Similarly, Bopp and Lady (1991)
find that, when deseasonalized data are employed, the predictive signif-
icances of both the spot and futures price series turn out to be about be
the same. However, when the actual prices are employed, futures price
does correctly anticipate the observed seasonal pattern.
Since the spot and futures prices are normally found to follow unit-
root processes with the two series being cointegrated, some studies
incorporate the existence of cointegration in the analysis of price
discovery. For example, Quan (1992) uses monthly data on crude oil
and tests for the cointegration and price discovery. Quan (1992) finds
evidence that the spot crude oil market always leads the futures market
and that the crude oil futures market does not play an important role in
the price discovery. Schwarz and Szakmary (1994) suspect that Quan's
(1992) results are influenced by the monthly data used in the study due

http://dx.doi.org/10.1016/j.eneco.2014.06.007
0140-9883/© 2014 Elsevier B.V. All rights reserved.
230 K. Shrestha / Energy Economics 45 (2014) 229–233
to the fact that monthly data may fail to capture the short-term dynam-
ics. Therefore, Schwarz and Szakmary (1994) empirically analyze mar-
kets for crude oil, heating oil and unleaded gasoline using daily data
instead of monthly data. They also extend the price discovery measure-
ment suggested by Garbade and Silber (1983) by introducing the error
correction term following the concept of cointegration developed by
Engle and Granger (1987). They find that the price discovery mainly
takes place in the futures markets. Silvapulle and Moosa (1999) use
both linear and non-linear causality tests on the spot and futures prices
for crude oil. The linear causality test reveals that futures price leads
spot price. However, the nonlinear causality test reveals a bidirectional
causality. Bekiros and Diks (2008) find similar bidirectional nonlinear
causality in crude oil spot and futures prices. In a regional study,
Kaufmann and Ullman (2009) conclude, based on price innovations,
that the futures prices of light crude on the New York Mercantile
Exchange (NYMEX), along with the spot prices of Dubai crude, provide
new information about the petroleum market.
Similar to Schwarz and Szakmary's (1994), there are alternate
methods of measuring price discovery which are also based on the
concept of cointegration. One such method is based on the Gonzalo–
Granger permanent–temporary (PT/GG) decomposition method pro-
posed by Gonzalo and Granger (1995). For example, Silvério and Szklo
(2012) estimate the time series of price discovery in futures market
based on the PT/GG method by using time-varying parameter model
and Kalman filter technique. Using the daily data on crude oil spot and
futures prices from January 10, 1990 to October 8, 2010, they find
evidence that the futures market's contribution to price discovery has
been increasing throughout the time period they analyze.
Another popular method is the so-called information share (IS) mea-
sure proposed by Hasbrouck (1995) where the price discovery or the
information share of market i is based on the fraction of the long-run
impact of the innovation represented by market i. However, the IS
measure leads to the upper and lower bounds for the information
share instead of a unique measure. Another limitation of IS measure is
that it can only be applied to the case where the cointegrating relation
between the futures and spot prices is one-to-one. Lien and Shrestha
(2014) suggest a way to modify Hasbrouck's IS measure that solves
both the limitations. The modified IS measure is called generalized
information share (GIS).
In this study, we analyze the price discovery mechanism for three
commodities in the energy sector. These three commodities include
crude oil, heating oil and natural gas. We use daily data available in
Datastream that ends on 31 December 2013. We use both the GIS and
PT/GG methods to analyze the price discovery.2 In all three cases, we
find both the spot and futures price series to be non-stationary with sin-
gle unit roots. Furthermore, each pair of spot and futures prices is found
to be cointegrated with single cointegrating vector. Based on both GIS
and PT/GG methods, we conclude that for heating oil and natural gas, al-
most all the price discovery takes place in the futures market, consistent
with the finding of Schwarz and Szakmary (1994). However, for the
crude oil, even though a higher level of price discovery takes place in
the futures market compared to the spot market, the difference is not
significant, implying that the price discovery takes place in both mar-
kets. This result is consistent with the bidirectional causality found by
Bekiros and Diks (2008). In sum, our evidence shows that the futures
markets perform an important price discovery function in addition to
facilitating the hedging activities. The empirical evidence presented in
this study has important policy implications. Policy makers would like
to have efficient markets where the prices reflect fundamental values
because prices play an important role in the allocation of resources in
a free-market economy. Our results show that the establishment of
the futures market is important for the efficient markets. Therefore, pol-
icy makers should encourage the establishment of futures markets and
2 4
Please see Lien and Shrestha (2014) for the description of these methods.
Table 1
Commodities used.
This table lists the commodities, sample periods and sample sizes used for the empirical
analysis in this study. All the three futures contracts are traded in the New York Mercantile
Exchange (NYMEX).
Commodity Begin date End date Sample size
Crude oil 30 March 1983 31 Dec. 2013 7,726
Heating oil 27 September 1979 31 Dec. 2013 8,637
Natural gas 1 November 1993 31 Dec. 2013 5,048
should establish institutions, laws and regulations conducive to the
development of futures markets. Similarly, exchanges which portray
themselves as highly efficient exchanges in order to attract multiple
listings or IPOs should also try to establish futures markets for more
commodities.
The rest of the paper is organized as follows. We present the empir-
ical results in Section 2. The paper concludes in Section 3.
2. Empirical results
In this study, we analyze the price discovery process in markets for
three energy-related commodities. They include markets for crude oil,
heating oil and natural gas. All three futures contracts are traded on
the New York Mercantile Exchange (NYMEX). We use the daily data
available in Datastream. Due to the availability of data in Datastream,
the starting dates are different for different commodities. However, all
of them have the same ending date which is 31 December 2013. The in-
formation on the samples is given in Table 1. The daily closing futures
and spot prices for the crude oil, heating oil and natural gas are plotted
in Figs. 1, 2, and 3, respectively. Since the futures and spot prices are very
close to each other, we shift the spot price by adding constant values as
indicated in the captions for the figures. As can be seen from the figures,
there are large variations in the futures and spot prices. This allows us to
perform reliable statistical analysis intended in this study. In all the
analyses, we use the logarithm of the spot and futures prices.
Before we present the empirical results, we briefly discuss about the
appropriate choice for the level of significance used in the empirical
analysis. In the conventional empirical tests, we use 5% as the standard
level of significance, with 10% and 1% as the other two levels of signifi-
cance being used. The choice of the 5% level is reasonable when we
are dealing with samples that consist of a few hundred observations.
However, when the samples are large (e.g., samples with thousands of
observations), the standard errors are very small and it is likely that
we end up rejecting most of the null hypotheses at the 5% level because
any small deviation from null hypothesis may end up being significant
due to small standard errors.3 Econometricians suggest using a lower
level of significance in the case of large sample size (Greene, 2003).
Therefore, in this study, we use 2.5% level instead of 5% level.
In order to compute the generalized information share (GIS) mea-
sure, we need to establish the pre-condition that each of the series
under consideration is non-stationary, i.e., each of the series consists
of a single unit-root. We use the Phillips–Perron (PP) (Phillips and
Perron (1988)) unit-root test on the logarithm of prices.4 The results
are summarized in Table 2. Each of the unit-root tests for the logarithm
of prices is insignificant at the 2.5% level. This implies that each of the se-
ries is non-stationary at the 2.5% level of significance. In order to test to
see if the series have multiple unit-roots, we also perform the PP test on
the first-differenced series. Each of the unit-root test statistics for the
first-differenced series is highly significant. Therefore, based on the PP
test, we can conclude that each of the series is non-stationary with a
single unit-root.
3
See Lin et al. (2013) and Greene (2003) for discussion on this issue of large sample size
and its impact on hypothesis testing.
The augmented Dicky–Fuller tests led to identical conclusions.
 K. Shrestha / Energy Economics 45 (2014) 229–233
250
200
150
100
50
Fig. 1. Daily crude oil futures and spot price from 30 March 1983 to 31 December 2013 where spot price is shifted up by 50 by adding 50 to the spot price series.
600
500
400
300
200
100
Fig. 2. Daily heating oil futures and spot price from 27 September 1979 to 31 December 2013 where spot price is shifted up by 100 by adding 100 to the spot price series.
Since the uniformly most powerful test does not exist in testing unit-
root, it is important to use alternate tests to establish that all the series
considered are unit-root series. As the null hypothesis under the
Phillips–Perron test is unit-root, we also use the KPSS (Kwiatkowski
et al., 1992) test which assumes stationarity as the null hypothesis.5
The results of KPSS test are also summarized in Table 2. It is clear that
the null hypothesis of stationarity is rejected for all series considered,
even at the 1% level of significance. Furthermore, the null hypothesis
cannot be rejected even at the 10% level for the differenced series.6
Therefore, the KPSS test results also indicate that each of the series con-
sidered in the study has a single unit-root.
Finally, following Serletis (1992), we use Zivot–Andrews (Zivot and
Andrews, 1992) test, which allows for one endogenous structural break,
to test for the unit-root. The test results are summarized in Table 3. Our
results for futures prices are similar to the ones reported by Serletis
(1992) where Serletis (1992) finds the Zivot–Andrews test to be signif-
icant at the 5% level for crude oil, heating oil and unleaded gas futures
prices. As discussed earlier, due to large sample sizes, we choose the
2.5% level of significance in our empirical analysis. Based on the 2.5%
level of significance, Zivot–Andrews test rejects the null hypothesis of
unit-root only for the logarithm of spot price for natural gas.
In addition to the empirical evidence presented above, we consider a
theoretical argument. It is well known that market efficiency implies that
logarithm of prices are unit root (Serletis, 1992). Therefore, based on the
5
We would like to thank one of the referees for suggesting the use of the KPSS and
Zivot–Andrews tests in our empirical analysis.
6
In order to save space, both the PP and the KPSS tests on the differenced series are not
reported.
231
Futures
Spot
Futures
Spot
theoretical argument as well as the majority of the unit-root test results,
we conclude that the logarithm of spot and futures prices follows unit-
root process.
Once it is established that each series has a single unit-root, we want
to perform tests to see if cointegrating relationship between the futures
and spot prices exists for each of the three pairs of futures and spot
prices. We apply the Johansen (1991) cointegration test for the exis-
tence of cointegrating relationship. The results are summarized in
Table 4. We report both the λmax and the trace statistics. Table 4 also re-
ports the slope and the intercept of each of the cointegrating vectors. In
the cointegration test, we use the logarithm of spot price as the first
series and the logarithm of futures price as the second series. Both the
λmax and trace statistics are highly significant for the zero cointegrating
vector. This is true for each of the three pairs of futures and spot prices.
Next, we test for the existence of at most one cointegrating vector. Since,
for this test, λmax and trace statistics are identical, we only report the
λmax statistic. The λmax statistic for each of the three pairs of commodi-
ties is insignificant. Therefore, based on these statistics, we conclude
that there exists a single cointegrating relationship between the futures
and spot prices. This result is not surprising given that, theoretically,
both the futures and spot prices are related to each other through the
cost-of-carry no-arbitrage argument.
So far, we have established that the logarithm of spot and futures
prices is non-stationary with single unit roots for crude oil, heating oil
and natural gas. We have also established that there exists a single
cointegrating vector for each pair of spot and futures prices. Therefore,
we have satisfied the conditions necessary for the use of GIS and PT/
GG based information share measures in the analysis of the price dis-
covery process. The computed GIS measures are reported in Table 5.
232 K. Shrestha / Energy Economics 45 (2014) 229–233

30
Futures
Spot
25

20

15

10

Fig. 3. Daily natural gas futures and spot price from 1 November 1993 to 31 December 2013 where spot price is shifted up by 5 by adding 5 to the spot price series.

positive sign. Therefore, in the computation of the PT/GG based infor-

Table 2
Unit-root test results. mation share, we replace the negative estimates of α2 for heating oil
This table summarizes the results of the Phillips–Perron (PP) and Kwiatkowski–Phillips– and natural gas with 0. The PT/GG based information share measures
Schmidt–Shin (KPSS) unit-root tests on logarithm of spot and futures prices. The critical are also reported in Table 5. Based on these measures, we conclude
values for PP test are − 2.557, − 2.861, −3.122, and −3.430 at 10%, 5%, 2.5%, and 1% that for the heating oil and the natural gas, the price discovery takes
significance levels, respectively. The critical values are generated using techniques
described in MacKinnon (1996). Similarly, the critical values for the KPSS test are 0.347,
place only in the futures market. As for the crude oil, the price discovery
0.463, 0.574, and 0.739 at 10%, 5%, 2.5%, and 1% significance levels, respectively. measures for the spot and futures markets are 39.56 and 60.44, respec-
tively. This indicates that more price discovery takes place in the futures
Series Log of spot price Log of futures price
market compared to spot market so far as the crude oil is concerned. In
Panel A: PP test order to test whether the difference is statistically significant, we per-
Crude oil −1.088 −1.011
form a likelihood ratio (LR) test based on the following hypotheses:
Heating oil −1.230 −0.881
Natural gas −2.885* −2.331

Panel B: KPSS test H 0 : α 2 ¼ −α 1 ; H 1 : α 2 ≠−α 1

Crude oil 8.046*** 8.058***
Heating oil 6.958*** 7.01***
Natural gas 3.912*** 4.088*** where the acceptance of null hypothesis means that the difference in
PT/GG based information shares is not significant, i.e., μ1 = μ2. The LR
***, **, and * indicate the test statistic to be significant at 1%, 2.5%, and 5% significance levels,
respectively. test static is equal to 0.8510 with a p-value of 35.65%. Therefore, we
conclude that the difference in the PT/GG based information share
measures for the spot and futures markets is not statistically significant
Based on GIS, it is clear that for heating oil and natural gas, almost all of
for crude oil. Therefore, we conclude that the price discovery takes place
the price discovery takes place in the futures market, where the GIS
in both the spot and futures markets in the case of crude oil. There are
measures are more than 95%. As for the crude oil, the GIS measures
few possible explanations for this result. Firstly, spot markets for
are 45.44% and 54.56% for the spot and the futures prices, respectively.
heating oil and natural gas are more or less localized markets and
This implies that more price discovery takes place in the futures market
futures markets play an important role in price discovery in such mar-
compared to the spot market. However, a significant level of price dis-
kets. However, the spot market for crude oil is an international market
covery also takes place in the spot market for the crude oil.
with many participants including big and well informed oil companies
Next, we compute the PT/GG based information share measure. Let
as well as oil refineries. These players can eliminate arbitrage opportu-
μ1 and μ2 denote the PT/GG based information shares for the spot
nities in spot markets as well. Therefore, we expect the price discovery
price (i.e., the first series) and futures price (i.e., the second series),
to take place in the spot market as well as the futures market for crude
respectively. Then, μ1 and μ2 are given by7
oil. Secondly, our results are based on daily data and it is possible that, at
α2 −α 1 least for the crude oil, one day is long enough for the spot price to reflect
μ1 ¼ & μ2 ¼ fundamental information.
α 2 −α 1 α 2 −α 1

where α1 and α2 are the adjustment coefficients for the spot and futures Table 3
prices, respectively. We expect the estimate of α1 to be negative and the Zivot–Andrews unit-root test results.
estimate of α2 to be positive so that any disequilibrium in the spot and This table summarizes the results of the Zivot–Andrews unit-root tests on logarithm of
spot and futures prices which allow breaks in both the intercept and linear trend. The
futures prices on any given day would partially be corrected on the fol- critical values are −4.82, −5.08, −5.30, and −5.57 at 10%, 5%, 2.5%, and 1% significance
lowing day through the appropriate change in the spot and the futures levels, respectively.
prices. As reported in Table 4, all three estimates of α1 are negative as
Series Log of spot price Log of futures price
expected. However, the estimates of α2 for heating oil and natural gas
are negative with only the estimate of α2 for crude oil having the correct Level Break Level Break

Crude oil −5.265* 17 Feb. 1999 −4.994 17 Feb. 1999

Heating oil −5.11* 22 Feb. 1999 −4.777 2 Jun. 1999
Natural gas −5.316** 8 Jul. 2008 −5.055 7 Jul. 2008
7
See Lien and Shrestha (2014) for the description of the PT/GG based information share ***, **, and * indicate the test statistic to be significant at 1%, 2.5%, and 5% significance levels,
measure. respectively.
 K. Shrestha / Energy Economics 45 (2014) 229–233
Table 4
Cointegration test results.
This table summarizes the results of Johansen tests on number of cointegrating vectors with lag length determined by AIC criterion. BIC and Hann–Quin criteria also provide similar results.
The critical values are taken from Osterwald-Lenum (1992). In the tests, we use the logarithm of spot price to be the first series and the logarithm of futures price to be the second series.
Coefficient Intercept
Crude oil −0.998 −0.007
Heating oil −0.991 −0.044
Natural gas −0.988 −0.003
***, **, and * indicate the test statistic to be significant at 1%, 2.5%, and 5% significance levels, respectively.
In sum, we find that futures markets, for the three energy-related
commodities analyzed in this study, play an important role in the
price discovery process. Furthermore, we know that energy plays an im-
portant role in the GDP and economic growth of a country. Finally,
prices play an important role in the efficient allocation of finite re-
sources to various uses. Therefore, from the policy makers' point of
view, they would prefer to have markets for energy where prices reflect
the true or fundamental value. This study presents evidence that the es-
tablishment of futures markets will help prices to reflect true or funda-
mental values. Therefore, policy makers should encourage the
establishment of futures markets. This can be done by establishing insti-
tutions or laws and regulation conducive to the development of futures
markets. Furthermore, the stock exchanges all over the world which
portray themselves as highly efficient markets to attract international
listing, including IPOs, should try to establish futures markets for more
commodities.
3. Conclusion
In this study, we analyze the price discovery in the spot and futures
markets for three important energy-related commodities like crude oil,
heating oil and natural gas. We use daily data which include recent data
up to 31 December 2013. We incorporate two different information
share measures to analyze the price discovery process. The first one is
the so-called generalized information share (GIS) proposed by Lien
and Shrestha (2014) which is based on the original information share
(IS) measure proposed by Hasbrouck (1995) and later on modified by
Lien and Shrestha (2009). The second method is based on
the permanent–temporary decomposition proposed by Gonzalo and
Granger (1995) (PT/GG).
Both measures indicate that, for heating oil and natural gas, almost
all the price discovery takes place in the futures market. However, as
for the crude oil, the price discovery takes place in both the spot and
futures markets. Our study indicates that futures markets serve an
important function of price discovery in addition to facilitating the
hedging activities.
Our empirical results have significant policy implications. It is well
recognized or commonly believed that prices play an important
allocational role in a free market economy because they contain infor-
mation that facilitates the efficient allocation of limited resources.
Therefore, policy makers would want to have well functioning markets
where prices reflect their fundamental value and where any new
Table 5
Information share measure.
This table summarizes the generalized information share measure (GIS) for the spot and
futures prices. It also reports the PT/GG information share measure.
Name GIS information share PT/GG information share
Spot price Futures price Spot price
Crude oil 0.4544 0.5456 0.3956
Heating oil 0.0446 0.9554 0 1
Natural gas 0.0009 0.9991 0 1
233
Number of cointegrating vec. Adjustment coefficients
None At most one
λmax Trace λmax α1 α2
347.983*** 349.360*** 1.377 −0.302 0.198
138.448*** 139.592*** 1.144 −0.080 −0.028
83.736*** 89.481*** 5.745 −0.096 −0.013
information is rapidly reflected in prices. Our empirical results show
that futures markets help prices reflect their fundamental value.
Therefore, policy makers should encourage the establishment of futures
market whenever possible.
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