Derivatives markets, storage and price volatility

Michael Giberson

I found this discussion of spot oil prices, futures prices, and commodity storage to be insightful:

[R]ecent evidence suggests that the combination of derivative prices and storage stabilized rather than destabilized the oil markets.

Indeed, during the run up in oil prices at the beginning of 2008 the spot price for oil was considerably higher than the futures price for delivery in 12 months, providing an incentive to reduce storage.   By taking oil out of storage and putting more supply on the market, the spot price increase was dampened.  Then at the end of 2008 as spot prices for oil were crashing, futures prices stayed above spot prices, creating an incentive to store oil, softening the collapse.

If anything, the volatility in the oil markets over this period of time was caused by a lack of storage capacity that has not grown nearly as fast as the overall oil market.  So if policymakers are serious about dampening volatility, they should encourage the growth in storage capacity.  What does this have to do with derivatives markets?  An active derivatives market makes investments in storage facilities more attractive, because it reduces the risks associated with storing commodities.  Hence, policy initiatives to dampen speculation and hedging in derivatives markets are likely to make storage less attractive, which will in turn, increase rather than decrease the volatility of the actual physical commodity prices.

I wonder how this idea would translate into electric power markets and grid-connected energy storage?