Advances In Management

Vol. 6 (8) Aug. (2013)

Case Study:

An Empirical Analysis on Long Term and Short Term Relationship between the Spot and Future Prices of India Crude Oil Market
Purushothaman S.* and Velmurugan P.S.
Department of Commerce, School of Management, Pondicherry University, Puducherry 605 014, INDIA *s.purushoth2006@gmail.com

Abstract
The present study is to test for the existence long term and short term relationships between Spot and future of crude oil prices from India (MCX). The crude oil spot and future price is collected. 2018 observations are collected from Multi Commodity Exchange (MCX) from 29th April 2005 to 31st December 2011. In the study we used Johansen co-integration and Vector error correction model (VECM) respectively. The first step in the analysis is stationarity of spot and future prices of crude oil through unit root test ADF and PP test. Two variables are stationary at 1st difference. Based on the Johansen co-integration and Vector error correction model (VECM), the price discovery is achieved from the both the market and has long term and short term relationship between them at 1%, 5% level of significance.
Keywords: Indian Crude Oil Market, Spot and Future Prices, Short term, Long term, Relationship.

Moreover, the co-integration and its corresponding error correction model assume that the tendency to move toward a long-run equilibrium is always present. However, it is possible that an adjustment towards equilibrium need not occur in every period.6 The price transmissions between spot and futures in Taiwan TECM clearly indicated a bidirectional feedback causality relationship between the spot and futures markets. Asymmetric price transmissions between these two markets are also found in the long run.6 The price discovery function of futures markets hinges on whether new information is actually reflected first in changes in futures prices or in spot prices. Identifying the direction of information flows between spot and futures prices, then, appears to be an empirical issue. There exist many studies exploring the linkage of spot and futures prices for predictability, market efficiency and cointegration.7 Some works find that spot and futures price are not co-integrated, or they are co-integrated, but do not move together one-for-one in the long run. Recent studies focus on investigating the non-linear causality between spot and futures oil markets.1 However, our aim of the present study is to test for the existence relationships between Spot and future of crude oil prices from Multi commodity Exchange (MCX), which is used as an indicator of Indian oil market.

Introduction
Crude oil futures and spot prices reflect the same aggregate value of the underlying asset and considering that instantaneous arbitrage is possible; futures should neither lead nor lag the spot price.1 However, the empirical evidence is diverse, although the majority of studies indicate that futures influence spot prices but not vice versa. The futures prices respond to new information more quickly than spot prices, due to lower transaction costs and flexibility of short selling. 2 The hedgers and speculators will react to the new information by preferring futures rather than spot transactions. Spot prices will react with a lag because spot transactions cannot be executed so quickly.3 A large number of empirical studies has shown that most economic variables exhibit an asymmetric adjustment process. Some recent literature suggested that the dynamic relationship between spot and futures prices may be characterized by a nonlinear equilibrium correction model due to factors such as non-zero transaction costs, infrequent trading etc.4 The dynamic interrelationship between spot and futures suggested a nonlinear relationship between spot and futures.

Review of Literature
1. Apostolos Serletis10 examined evidence concerning the number of common stochastic trends in a system of three petroleum futures prices (crude oil, heating oil and unleaded gasoline) using Johansens maximum likelihood approach. The results indicate the presence of only one common trend. Li-Hsueh Chen et al11 studied new supportive evidence for asymmetric adjustment in U.S. retail gasoline prices. The asymmetric transmission is found to occur not just through the spot markets of crude oil and refinery gasoline but also through their future markets. Further evidence also shows that the observed asymmetry in price transmission primarily occurs downstream not upstream of the transmission process. Ercan Ozen et al12 examined short term or long term causality between the futures transactions carried out in

2.

*Author for Correspondence (13)

3.

Advances In Management
Izmir Derivatives Exchange (VOB) over Istanbul Stock Exchange Index (MKB30) and IMKB Index was investigated. To this end the 1024 days' cash price data and futures prices data belonging to the period between 4 February 2005 and 27 February 2009 were used. Unit Root test, Co integration test and causality analysis depending on Error correction model (VECM) were employed. The findings of the study proved that causality from VOB towards IMKB was detected in long term. In short term, on the other hand, IMKB was detected in long term. In short term, on the other hand, IMKB was found to be the causal of VOB. 4. Thai-Ha Le1 and Youngho Chang13 investigated the relationship between the prices of two strategic commodities: gold and oil. They studied through the inflation channel and their interaction with the index of the US dollar. They used different oil price proxies for their investigation and found that the impact of oil price on the gold price is not asymmetric but non-linear. Further, results show that there is a long-run relationship existing between the prices of oil and gold. The findings imply that the oil price can be used to predict the gold price. H0 : = 0

Vol. 6 (8) Aug. (2013) . (2)

which means that the data needs to be differenced to make it stationary. The alternative hypothesis is: H0 : < 0 . (3)

which means that the data is trend stationary and needs to be analyzed by means of using a time trend in the regression model instead of differencing the data. The test statistic is conventional t-ratio for : t = /se()

. (4)

The Phillips-Perron (PP) Test

Phillips and Perron propose an alternative method of controlling for serial correlation when testing for a unit root called Phillips-Perron (PP) test. The PP method estimates the non-augmented Dickey-Fuller test equation: yt = yt-1 + x1

+ t

. (5)

It modifies the t- ratio of coefficient so that serial correlation does not affect asymptotic distribution of the test statistic. The PP test is based on the statistic.

Johansen Co-integration Test

The purpose of the co-integration test is to determine whether a group of non-stationary series are co-integrated or not and it explores the long-run equilibrium relationship among the variables. Under this study, Johansens co-integration tests have been used to assess the long-run predictability among spot and futures prices, using the Johansen co-integration test, assuming an n-dimensional vector Xt with integration of on order I, estimates a vector autoregressive models. Johansen and Juselius further improved the model by incorporating an error correction depicted as follows: k Xt = c + i Xt-1+t
i=1

Methodology
The empirical analysis in the present study is based on unit root test through ADF and PP test, co-integration and VECM respectively. The first step in the analysis is to subject the spot and future prices of crude oil to unit root tests or tests the series for stationarity. The present study uses co-integration and VECM test for long term and short term relationship among the spot and future prices of crude oil. The crude oil spot and future data 2018 observations are collected from Multi Commodity Exchange (MCX) from 29th April 2005 to 31st December 2011.

The Augmented Dickey-Fuller (ADF) Test

Sometimes, time series data are not in a stationary form. To transform it into a stationary form, an easy way is to difference the time series data. One way is to use the Augmented Dickey-Fuller (ADF) statistic. The ADF test constructs a parametric correction for higher-order correlation by assuming that the series follows an AR (p) process and adding lagged difference terms of the dependent variable to the right-hand side of the test regression as follow: yt = yt-1 + x1 + 1yt-1 + 2yt-2 + pyt-p+vt . (1) where x1 are optional exogenous repressors which may consist of constant or a constant and trend. The Null hypothesis of the ADF t-test is

. (6)

k-1 Xt = + i Xt-i+i Xt-k+t

i=1

. (7)

where Xt is an n x1 vector of the I(1) variables representing Crude spot (St) and crude futures (Ft-n) prices respectively, is a deterministic component which may include a linear trend term, an intercept term, or both, denotes the first difference operator, i is an n x r matrix of parameters indicating a and b, c is a vector of constants, k is lag length based on the Akaike information criterion (AIC) Schwarz information criterion (SC) and 1t is a t random error term which indicates how many linear combinations of Xt are stationary.9

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Advances In Management

Vol. 6 (8) Aug. (2013) used for using any models. The sample period of crude oil prices data from 2nd January 2005 to 31st January 2012 are plotted with aid of Eviews. We have to determine the trend of the series of being constant, linear or non-linear and etc. The oil prices series is shown in figure 1. In figure 1 it can be seen that the oil prices have mainly fluctuated in the range of about Rs. 1897 and Rs. 6245. According to the ADF and PP test for spot and future price of crude oil in table 2, the ADF test statistic for spot and future is -1.61385 and -1.4029 and strongly disagrees that the series is stationary. Thus, we do not reject the null hypothesis of being non-stationary at level. The ADF test statistic for spot and future prices of crude oil are 046.7928 and -43.5226 respectively. It strongly agrees that the series is stationary at 1st difference. The PP test statistic for spot and future price of crude oil is -1.50561 and 1.49775 respectively. We do not reject the null hypothesis of being non-stationary. We reject the null hypothesis in 1% significant level.

Vector Error Correction Model

To explain the VECM test, we will consider the often asked question in macroeconomics8: Is it Crude oil Spot(CS) that causes the Crude oil Future (CF) (CS CF) or is it the Crude oil Future(CF) that causes Crude oil Spot (CS) where the arrow points to the direction of causality? The Granger causality test assumes that the information relevant to the prediction of the respective variables, CS and CF is contained solely in the time series data on these variables. The test involves estimating the following pair of regressions:

.(8)

.(9) where it is assumed that the disturbances CS and CF are uncorrelated. In passing note that, since we have two variables, we are dealing with bilateral causality.

Table 1 Descriptive statistics of Crude Spot and future Prices

Crude future price 3520.753 3467.000 6245.000 1897.000 851.5361 0.740727 3.160560 186.7057* 0.000000 Crude spot price 3462.385 3401.000 6299.000 1695.000 859.9854 0.701276 3.256359 170.9306* 0.000000

Empirical Analysis
As per table 1, the mean of spot and future price crude is 3520.753 and 3462.385 respectively. Standard Deviation of spot and future price crude is 851.5361 and 859.9854 respectively. The value for skewness is 0.740727 and 0.701276 respectively. There is positive skewness possible among study period and the distribution has a long right tail. Kurtosis is 3.160560 and 3.256359 respectively. The kurtosis exceeds 3, the distribution is leptokurtic relative to the normal. Jarque-Bera test indicates that we do not reject null hypothesis of being normal distribution at 5% significance level. We rejected 1% significant level. However, the data is normal and time series is suitable to be Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability *1% level of significant

Fig. 1: Daily observation of Crude spot and future prices (15)

Advances In Management Table 2 Unit Root Tests for Spot and Future prices of Crude Oil
Particulars T-Value ADF Test Crude Spot Crude Future PP Test Crude Spot Crude Future *1% level of significant -1.61385 -1.4029 -1.50561 -1.49775 At Levels P-Value 0.4753 0.5823 0.5308 0.5348

Vol. 6 (8) Aug. (2013)

1st difference T-Value P-Value -46.7928* -43.5226* -46.8413* -43.5440* 0.0001 0.0000 0.0001 0.0000

Table 3 Co-integration Result Trace test results

Crude oil Spot Future Hypothesis r=0 r1 Eigen Value 0.027294 0.001130 trace Statistics 57.98112** 2.275322 5% Critical Value 15.49471 3.841466

Table 4 Maximum Eigenvalue results

Crude oil Spot Future **5% level of significant Hypothesis r=0 r1 Eigen Value 0.027294 0.001130 max Statistics 55.70579** 2.275322 5% Critical Value 14.26460 3.841466

Table 5 Crude Oil vector error correction model (VECM)

Commodity Constant ii=s,f (Error. correction) [T-Stat] Crude oil St 0.869488 (1.33389) [ 0.65184] 1.463796 (1.42779) [ 1.02522] St-1 (Error. correction ) [T-Stat] -0.309371 (0.02532) [12.2179]** 0.007719 (0.02710) [ 0.28481]** St St-2 (Error. correction) [T-Stat] -0.094535 (0.02065) [4.57870]** -0.030385 (0.02210) [1.37487]** Ft-1 (Error. correction ) [T-Stat] 0.663140 (0.02492) [ 26.6133]** 0.057196 (0.02667) [ 2.14444]** F Ft-2 (Error. correction ) [T-Stat] 0.188261 (0.02780) [ 6.77302]** 0.008625 (0.02975) [0.28989]** Zt-1 (Error. correction ) [T-Stat]

0.082886 (0.01408) [ 5.88517]* -0.058597 (0.01508) [3.88693]**

Ft

*1%, **5% level of significant

Johansens Co-integration
As the series were stationary at their first difference, their cointegration was tested using Johansen and Johansen and Juselius co-integration test. The aim of this test is to determine whether a long-term relationship exists between the variables, or not. Test results are presented on table 3 and 4. As a result of the two tests Null hypothesis is rejected at 5% level of significant.

It was determined that there is a single co integration vector between the series. As a result of the two tests there is a longterm relationship between Spot and futures of Crude oil. The test reveals that one co-integration relationship exists between spot and futures markets of crude oil. Johansens max and trace statistics reveal that the spot and futures prices of crude oil stand in a long-run relationship between them, hence both series have a conjugate movement in the long term.

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Advances In Management

Vol. 6 (8) Aug. (2013) unit root test ADF and PP test. The ADF test statistic for spot and future prices of crude oil are 046.7928 and -43.5226 respectively. It strongly agrees that the series is stationary at 1st difference. The PP test statistics for spot and future price of crude oil are -1.50561 and 1.49775 respectively. We do not reject the null hypothesis of being non-stationary at level. We reject the null hypothesis at 1% significant level stationary at 1st difference. As per Johansen and Juselius co-integration test, the aim of this test is to determine whether a long-term relationship exists between the variables or not. As a result of the two tests Null hypothesis is rejected at 5% level of significant. Johansens max and trace statistics reveal that the spot and futures prices of crude oil stand in a long-run relationship between them, hence; both series have a conjugate movement in the long term. Based on the Vector error correction model (VECM), it is indicated the spot price series St has a greater speed of adjustment to the previous periods deviation from long-run equilibrium than the future price series. It is consistent with the fact that spot price has to adjust itself to the prevailing future price. Crude oil future price VECM Result is a negatively adjustment to the previous periods deviation from long-run equilibrium than the spot price series. Both the market of crude oil is significant at 1% and 5% level. Thus, the results indicate that the price discovery is achieved from the both the market and has long term and short term relationship between them.

Vector error correction model (VECM)

Vector error correction model (VECM) is chosen on basis of Akaikes information criteria (AIC) The VECM estimation results are presented in table 5. Crude oil spot price VECM Result noticed that Zst-1 =0.082886. This indicates the spot price series St has a greater speed of adjustment to the previous periods deviation from long-run equilibrium than the future price series. It is consistent with the fact that spot price has to adjust itself to the prevailing future price equilibrium than the spot price series. Crude oil future price VECM result noticed that ZFt-1 = -0.058597 indicates the future price series Ft has a negatively adjustment to the previous periods deviation from long-run Vector error correction model (VECM) chosen on basis of Akaikes information criteria (AIC) . The VECM estimation results are presented in table. VECM result noticed that Zst-1 =0.082886. This indicates the spot price series St has a greater speed of adjustment to the previous periods deviation from long-run equilibrium than the future price series. It is consistent with the fact that spot price has to adjust itself to the prevailing future price. Crude oil future price VECM result noticed that ZFt-1 = -0.058597 indicating the future price series Ft has a negatively adjustment to the previous periods deviation from long-run equilibrium than the spot price series. A negative response implies the futures prices will decrease the variation and approach the equilibrium at the next period. This finding is consistent with the fact that on the delivery date of each the future price has negatively to adjust itself to the prevailing spot price. The results reveal that there is Bidirectional between the spot and future prices of Crude. Spot and Futures market significantly reacts to short-term variation and long-term equilibrium at the same time. Null hypothesis is rejected hence both the market of Crude oil is significant at 1% and 5% level (based on the Error correction). Thus, the results indicate that the price discovery is achieved from the both the market and has short term relationship between them.

References
1. Bekiros Stelios D. and Diks Cees G.H., The Relationship Between Crude oil spot and future Prices: Cointegration, Linear and Nonlinear Causality, 3 (2008) 2. Silvapulle P. and Moosa I.A., The relationship between spot and futures prices: evidence from the cruide oil market, The Journal of Futures Markets, 19, 175-193 (1999) 3. Chiung Chiao Chang, Asymmetric Causal Relationship between spot and futures in Taiwan, International Research Journal of Finance and Economics, 2 (2008) 4. Balke N. S. and Fomby T. B., Threshold Co-integration, International Economic Reviews, 38, 627-645 (1997) 5. Enders Walter and Siklos P. L., Co-integration and Threshold Adjustment, Journal of Business and Economic Statistics, 19, 166177 (2001) 6. Garbade K. and Silber W., Price movements and price discovery in futures and cash markets, Review of Economics and Statistics, 65 (2), 289297 (1983) 7. Bekiros S.D. and Diks C.G.H., The relationship between crude oil spot and futures prices: cointegration, linear and nonlinear causality, Energy Economics, 30, 2673-2685 (2008) 8. Gujarati; Basic Econometrics, Fourth Edition, the McGraw-Hill Company, 699 (2004)

Conclusion
Our aim of the present study is to test for the existence relationships between Spot and Future of crude oil prices from Multi Commodity Exchange (MCX) which is used as an indicator of Indian oil market, the researcher are examining dynamic relationships between spot and futures prices of crude oil. In this study the major objective is to find out long term and short term relationship between the spot and futures prices of Crude oil market from India. 2018 observations are collected from Multi Commodity Exchange (MCX) from 29 th April 2005 to 31st December 2011. In the study, we used Johansen co-integration and Vector error correction model (VECM) tests respectively. The first step in the analysis stationarity of spot and future prices of crude oil is through

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Advances In Management
9. Jabir Ali and Gupta Kriti Bardhan, Efficiency in agricultural commodity futures markets in India, Emerald in sight, 166 (2009) 10. Apostolos Serletis, A cointegration analysis of petroleum futures prices, Energy Economics, 16 (2) 93-97 (1994) 11. Li-Hsueh Chen, Miles Finney T. and Kon S. Lai, A threshold cointegration analysis of asymmetric price transmission from crude oil to gasoline prices, Economics Letters, 89, 233239 (2005)

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12. Ercan zen, Tunga Bozdoan and Muhittin Zgl, The Relationship of Causality between the Price of Futures Transactions Underlying Stock Exchange and Price of Cash Market: The Case of Turkey, Middle Eastern Finance and Economics (2009) 13. Thai-Ha Le1 and Youngho Chang, Oil and Gold: Correlation or Causation? Nanyang Technological University, Singapore Working Paper Series No. 2011/22 (2011).

(Received 22nd April 2013, accepted 2nd June 2013)

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