Econometric model for forecasting Indonesian Crude Price and its Application in cross hedging strategy on futures contract (6th IAEE European Conference, Zurich – Switzerland, Sep 2004)

September 12, 2004 • Tell FriendsPrinter Friendly

 

Abstract

 

 

The volatility of the world oil market since the OPEC oil price shocks of the 1970’s has resulted in oil export dependent countries like Indonesia facing a considerable degree of macroeconomic risk. Declining oil revenues resulted in large public sector deficits and a worsening balance of payments situation.

Indonesia’s dependence on oil is such that even minor if oil price declines have had a substantial cumulative adverse impact on Indonesia’s macroeconomic performance. The need of the forecasting model in predicting the Indonesian crude price is greatly required to give guidance for government budget planning and also for hedging scheme.

Error correction model developed by Engle-Grager can be used to forecast price change as long as two variables which is non stationery are cointegrated in the same order. One of the advantage of this model is it can accommodate the short and long information in one model. The availability of error correction term (cointegration vector) in the model can correct any deviation happened into equilibrium in the long term.

Developing countries like Indonesia have sought to achieve export revenue stabilization through International Commodity Agreements with importing nations. An alternative approach to stabilizing export revenues is to use market based risk management tools such as futures hedging. Through futures hedging cannot insulate exporters from a long term secular decline in commodity prices; they are effective in managing short term price risk. Using futures market for hedging is a notion that is just now beginning to gain acceptability among developing countries. The New York Mercantile Exchange (NYMEX) estimates that developing countries are increasingly holding a higher percentage of the total open interest in crude oil futures. Since the gulf war, countries like Mexico, Brazil, and Chile are regular users of the oil derivatives market. (Satyanarayan, 1997)

The objective of this paper is to find the error correction model for forecasting changes in Indonesian Crude and WTI spot price, also to assess the risk management prospect for hedging Indonesian crude by developing scenario model of hedging and use it to evaluate the cost and benefits of different hedging strategies.

This paper shows that there is effective risk reducing strategies available to Indonesian policy markets that would have reduced the variance of Indonesian oil revenues over time. While these strategies may necessitate foregoing unexpected gains, they would have prevented unanticipated short term losses. We provide estimates of the cost and benefit of different hedging strategies that may aid in policy formulation.

Cointegration is found among Indonesian Crude and WTI spot price using the two stage Engle-Grager methodology and a series of error correction models are estimated. Using 72 months of “out of sample” data, the null hypothesis of no forecasting ability is rejected at a 2% level of significance for the ECM model found.

This paper also tests for cointegration between the spot and future price of WTI. It is purposed to estimate the closing price of WTI Futures contract so that we can know what position that will be held in the futures contract.

By using these two prediction model, we can make a simulation of cross hedging strategies on futures market. The result of simulation has an effect of increasing the mean, reducing the variance and positively skewing the distribution of gross profit over a naïve strategy.


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