A Proposal to Fix the Number of Factors on Modeling the Dynamics of Futures Contracts on Commodity Prices

In the literature on modeling commodity futures prices, we find that the stochastic behavior of the spot price is a response to between one and four factors, including both short- and long-term components. The more factors considered in modeling a spot price process, the better the fit to observed futures prices—but the more complex the procedure can be. With a view to contributing to the knowledge of how many factors should be considered, this study presents a new way of computing the best number of factors to be accounted for when modeling risk-management of energy derivatives. The new method identifies the number of factors one should consider in the model and the type of stochastic process to be followed. This study aims to add value to previous studies which consider principal components by assuming that the spot price can be modeled as a sum of several factors. When applied to four different commodities (weekly observations corresponding to futures prices traded at the NYMEX for WTI light sweet crude oil, heating oil, unleaded gasoline and Henry Hub natural gas) we find that, while crude oil and heating oil are satisfactorily well-modeled with two factors, unleaded gasoline and natural gas need a third factor to capture seasonality.