Sunday, October 07, 2007

Backward Oil

Interesting article in the Wall Street Journal Weekend Edition (starting on the front page of the print edition). Over the past 12 months the price of oil has risen by about $21/barrel. But that’s just if you want the oil right now. The futures price of oil for delivery 2 years hence has only risen by about $8/barrel.

A year ago, the oil futures markets were in contango, meaning that distant futures were more expensive than spot oil. There is a theory that contango is normal for most commodities, since by buying distant futures, you can avoid storage costs (including the cost of financing inventories) and therefore should be willing to pay more than if you had to store the commodity yourself. Apparently, a year ago, the contango was too severe to be explained by storage costs. The usual explanation is that traders were worried about demand oustripping supply in the future – so much so that they were willing to give anyone with storage capacity a strong incentive to use that capacity. That has to be only part of the explanation, though. The other part is that oil producers were not so worried about demand outstripping supply in the future; otherwise they would have put off production into the future (expecting prices to rise) and driven up the spot prices. So presumably the contango happened because speculators were more bullish on oil than producers were. (I guess the speculators got it right this time – so far anyhow.)

But as I understand it (from casual reading: I’m no oil expert), contango is not normal in the oil market. The situation today – known as backwardation – where spot prices exceed distant futures prices – is apparently much more typical. The standard “theory of normal backwardation” (due to John Maynard Keynes) is that producers, being risk-averse, are willing to accept lower prices on distant contracts in order to lock in a price rather than being subject to unpredictable price changes. That theory works even for competitive markets, but I’ve heard that there is something else going on in the partially monopolized oil market – namely that OPEC (and perhaps Saudi Arabia in particular) deliberately tries to keep spot supplies tight in order to maximize its control over spot prices. In other words, it’s not because producers sell the futures; it’s because they refuse to sell enough of the spot.

I wonder if what’s going on is an interaction between producer expectations and producer capacity constraints. If producers a year ago (and in recent years in general) expected prices to fall (as some of their public statements suggested, though such statements are often seen as untrustworthy), they would have an incentive to produce at full capacity. And if, for example, Saudi Arabia was producing at full capacity, it might also have had an incentive to increase capacity so as to have more control over prices in the future. If capacity has subsequently increased relative to demand, and if the Saudis have begun to doubt their forecasts for falling prices (which one could imagine they might have, since the forecasts keep being wrong), then we’re back to the old situation where they hold back on production to keep control over spot prices.

I’m not sure if this makes sense. I’m not sure what it means. I’m not sure if it’s bullish or bearish for oil. But it seems really interesting.

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22 Comments:

Anonymous Anonymous said...

"The other part is that oil producers were not so worried about demand outstripping supply in the future; otherwise they would have put off production into the future (expecting prices to rise) and driven up the spot prices."

It's not clear why this would happen. Even if a producer expected demand to fall in the future, she still has an incentive to sell oil at the higher future price (putting off production) and arbitrage the storing costs away.

Sun Oct 07, 07:26:00 AM EDT  
Blogger Marc Shivers said...

A couple points of interest:

1. The historically normal level of backwardation for the oil curve has been about 50bps/month.

2. Among commodities, there's a direct positive relationship between inventory levels (in days of supply) and level of contango. Gold, which has something like 13 years of supply, is always in contango; copper is at the other end of the spectrum.

The Cleveland Fed put out a high-level piece on the topic a while back: Oil Prices: Backward to the Future? (pdf)

Sun Oct 07, 10:06:00 AM EDT  
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