Seasonal and stochastic effects in commodity forward curves

In this paper we develop a new model for the dynamics of forward curves of commodities exhibiting seasonalities, such as natural gas, electricity or agricultural commodities. In the existing literature on the subject, the first state variable in multi-factor models is the commodity price, which combines seasonal and stochastic features and may be unobservable. We propose to use instead the average forward price, which is devoid of seasonality and conveys a more robust representation of the current forward curve level. The second factor in the model is a quantity analogous to the stochastic convenience yield, which accounts for the random changes in the forward curve shape. The well-known cost-of-carry relationship is significantly improved by introducing a deterministic seasonal premium within the convenience yield. We develop model estimation procedures and apply them to a number of energy markets.