Are commodity prices mean reverting?

Abstract

Are commodity prices mean reverting or do they follow a random walk? As traditional unit root tests lack power, this article proposes using the ability to hedge option contracts as a measure of the most appropriate stochastic process. A misspecified price process will, quite naturally, result in larger hedging errors. The hedging errors, therefore, give an economic as opposed to statistical measure of mean reversion. Market prices of almost 300 different commodities from 1970 and onwards are studied. In line with the low power of statistical unit root tests, we are only able to reject a unit root for some 15% of the commodity price series and mean reversion is accepted for even fewer series. Hedging errors are, however, smaller for the mean reverting process, supporting the intuition that commodity prices are mean reverting.

Acknowledgements

The author is indebted to Peter Jennergren, Boualem Djehiche, Per-Olov Edlund, Kenth Skogsvik and Håkan Thorsell for helpful comments. An earlier version of this article has been presented at the Quantitative Methods in Finance Conference – Sydney 2003 and the article has benefited from comments received by the participants. Financial support from the Torsten and Ragnar Söderberg Foundation is gratefully acknowledged.