Price formation in commodity markets

This paper develops a theory-consistent market model for storable commodities and illustrates its characterization of the data-generating process for a set of major traded commodities. The dynamics of the system incorporate recent advances in modelling techniques. Cointegrated variables in the demand functions are represented by the error correction mechanism (ECM), and expected prices in the stock demand relationship are generated by a rational expectations process. The outside-sample performance of the model is tested against the pure time-series model used to formulate expected prices, and is shown to have a smaller mean square error than that of the time-series model. Thus the model provides comparatively efficient forecasts and, unlike models constructed in their reduced form, permits consideration of key behavioural relationships in commodity markets.