Basis risk, liquidity costs, and survival of the fittest in energy futures markets

An investigation of the determinants of success or failure of energy futures contracts was performed. In particular, the historical phenomenon of general failure among multiple contracts corresponding to a single commodity was examined. In the energy industry (and perhaps in other industries as well), after a futures contract has been successfully introduced for a commodity, it is usually the case that all other contracts subsequently introduced to trade in the same commodity fail, even if they specify different delivery points. The recent failure of the Kansas City Board of Trade (KCBOT) natural gas futures contract, which was introduced five years after the highly successful New York Mercantile Exchange (NYMEX) contract, was the focus of the present investigation.; Three alternative hypotheses explaining the failure of the KCBOT contract were tested: (1) that an efficient, integrated natural gas market made the existence of a second contract redundant, (2) that the NYMEX contract exhibited significantly superior hedging capabilities at most trading locations, and (3) that the relatively higher liquidity costs associated with the KCBOT contract, which were a consequence of its lower trading volume, more than offset any advantages that it may have offered as a superior hedging instrument. The first hypothesis was tested by a correlation analysis of natural price movements at ten distinct trading regions; the second two hypotheses were tested by applying linear regression analysis.; The findings indicate that none of the three hypotheses provided a satisfactory explanation of the KCBOT contract's failure. The natural gas market is not yet a fully integrated market, the KCBOT contract actually exhibited superior hedging capabilities over NYMEX at most trading locations, and market integration and price elasticity were found to be insignificant determinants of contract trading volume. However, the results of the linear regression analyses, as well as historical data on trading participation, indicate that one of the more significant contributors to the KCBOT contract's demise was its inability to attract speculators.