Crude Oil Prices and the Yield Curve Spread - Hoteling's Rule 2.0?

Hoteling’s Rule 2.0?

In 1931, Harold Hoteling published his article “The Economics of Exhaustible Resources” in the Journal of Political Economy.  In that article he argued that the net price of a natural resource (i.e. a non-renewable asset) must grow at the rate of interest. 

The principal concept behind that article is that the value of a unit of that resource must be equal to its market price at that time, p(t), less the cost of extracting it at that time, c(t).  That means that the marginal value, V(t), equals p(t) – c(t).  Hoteling argued that the asset’s marginal value elasticity must be equal to the rate of interest, r, so V’(t)/V(t)=r. 

We would like to understand the relationship of rates to price rather than to marginal value, if possible.  By making the reasonable assumptions that the marginal cost of extracting the resource is independent of the extraction rate and the cost does not meaningfully change through time, then c(t) becomes a constant c.  This simple assumption results in the resource’s price elasticity to be directly proportional to the level of rates.

The point we are trying to make is that the Hoteling’s Rule leads us to consider oil prices (NYMEX in particular) in relation to the general level of rates.  While a relationship may or may not be true in the long term, and there are many articles arguing for a far more complex relationship if there is a relationship at all, the change in spot oil prices do indeed seem to follow the change in rates.  However it is the 2yr/10yr UST futures spread (TUT) that, since the end of 2010, we argue appears to have a meaningful correlation. 

Both markets experienced rapid increases beginning in September – October 2010 which exhausted themselves in the April and May 2011 time frames respectively.  Both markets then declined into September 2011 after which the TUT traded sideways until March of 2012 while spot oil experienced a 30% rally.  However following March 2012 both markets declined into July 2012, largely traded sideways until May 2013, experienced rallies up to September 2013 then selloffs through today.

2s10s Futures Yield Curve Spread (TUT)

NYMEX Crude Oil Prices

At times we may observe that the correlation is low, consider the September 2011 – March 2012 period where TUT traded sideways but oil experienced a 30% rally.   That said there does seem to be a mean reverting aspect to the differential between to the two markets as is obvious in the relative moves from March 2012 and to July 2012. 

It is our view that an oil TUT spread position is worthy of closer examination and is an inherently lower risk proposition vis-à-vis an outright position in either market.  The key, as in all mean reverting strategies, is to optimize profit potential by initiating positions when the divergence reaches its exhaustion point.

RIDE THE CURVE!