Trading Institutions and Price Discovery: The Cash and Futures Markets for Crude Oil

Albert Ballinger, Gerald P. Dwyer Jr., and Ann B. Gillette
Working Paper 2004-28
November 2004

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We provide substantial evidence that the futures market for West Texas Intermediate crude oil increased the short-term volatility of the cash price of crude oil. We show that the variability of prices increased using both published posted prices and transaction prices for producers. This increased volatility in the price of crude oil may reflect information aggregated into the price, an increase the variance of shocks to the price of crude oil, or noise in the futures price that affects the cash price. We present evidence from experiments consistent with the interpretation that information aggregation not feasible in a posted-price market can explain at least part of the increase in variance. This evidence supports the proposition that information not previously aggregated into the cash price for crude oil is at least part of the reason for the greater variability of the cash price after the opening of the futures market and provides at least one example in which a futures market increased the volatility of the cash market, and prices became more efficient.

JEL classification: G130, G140

Key words: crude oil, futures, posted price, experiments, experimental finance, price discovery, information aggregation

The authors appreciate helpful comments from Lucy Ackert, Raymond C. Battalio, Peter Bossaerts, David Dubofsky, Donald House, Peter Locke, Shyam Sunder, Robert van Order, Paula Tkac, and participants in seminars at the Commodity Futures Trading Commission, George Washington University, and in sessions at the Economic Science Association and Financial Management Association meetings. Some of Dwyer’s initial work on this paper was completed while he was a visiting financial economist at the Commodity Futures Trading Commission. Gillette’s initial work on this paper was completed while she was a visiting scholar at the Federal Reserve Bank of Atlanta and the College of Business Administration at Georgia State University. They also appreciate assistance by two crude oil producers who provided invoices and contracts. Qian Li, Nancy Lucas, Shalini Patel, Gwendolyn Penneywell, Anand Venkateswaran, and Wei Yu provided research assistance, and Linda Mundy provided editorial assistance. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Gerald P. Dwyer Jr., Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, NE, Atlanta, Georgia 30309-4470, 404-498-7095,; Albert Ballinger, University of Houston-Clear Lake, 46 Chapparal Court, Missouri City, Texas 77459, 281-499-4729,; or Ann B. Gillette, Kennesaw State University, Michael J. Coles College of Business, 1000 Chastain Road, Kennesaw, Georgia 30144, 770-499-3278,