Gas Prices, Peak Oil, Futures, Contango & Backwardation
The oil futures market is an interesting thing. I often wonder if the prices of oil on the futures market can actually predict the future of oil prices. For example, if the futures market could indeed predict $300/barrel oil, then we would know that the bad times were near at hand.
There are several possibilities for prices on the futures market. Let's look at a few in order...
1. The price of the contract is higher and higher, the farther the settlement date is in the future.
2. The price of the contract is lower and lower, the farther the settlement date is in the future.
3. The price is basically the same from now, all the way out.
4. The price of the contracts go up as you go to longer terms, and then come down somewhat.
5. The price of the contracts go down as you go out, and then start coming up.
Let's do some thought experiments on all of this.
What if the futures traders believed that the selling price (spot price) of a barrel of oil in December 2008 was going to be $100/barrel? It would make sense for them to purchase that contract. The more people that believed it would be that expensive, the more the price would go up. Each day, week, or month, the price of the December 2008 contract would be higher. Eventually, it would be $100/barrel.
What if the futures trader believe that the price would only be $30 per barrel. They would sell right now, in order to avoid losses. The more that believed it would go down to $30, the more would sell. Eventually, as we approached December 2008, the price would be down to $30.
So, the price right now reflects what is referred to as the "consensus view" of the price in December 2008. I believe this means that both buyers and sellers of that contract believe they are going to make money by buying or selling at that price. So, this could be thought of the halfway point between the most pessimistic view of the actual December 2008 price, and the most optimistic view, and all the views in between.
So what do all the possible scenarios that I listed above mean? The best article I've seen thus far is this one...
http://www.investopedia.com/articles/07/contango_backwardation.asp
This article describes that option 1 above, and perhaps option 4 are normal. The price for contracts further out are typically a bit more expensive than the current price. This is referred to as a "normal futures curve".
The article then describes option 2 and 5 as being "inverted market". Why would the price for later contracts be cheaper than now? Why would the futures traders "consensus view" be that the price in the future will be lower than now? Perhaps the price now is really high for a specific and temporary reason? This implies a shortage at the moment, which is or has driven up prices.
Option 3, the price being the same for a long way out, is extremely unlikely, particularly given inflation.
One interesting question is... If the futures price for the December 2008 delivery was 50% higher than the current price, what does that mean? Is there a huge surplus now? Or is there expected to be a big shortage later? Why would anyone buy something for a higher price that far out? Wouldn't they just buy it now, for the discounted rate, and store it until needed?
My understanding is that the current prices and the future contract prices are generally fairly close to one another. I suspect that as the price of one changes, so do the others.
NOW... not that the questions above have yet been examined in detail, but let us look at the prices in a different way.
Imagine that you had purchased that December 2008 contract for oil a year ago. At that time, the price was only $60/barrel. Since then, the price of that contract has been rising. It is now at $72/barrel. You have plotted the price of the December 2008 contract for the past year, and notice that the graph is sloping upwards. What does this mean?
According to the article linked above, this is called "backwardation". In other words, as time has passed, the price of that December 2008 contract has increased. What does this tell us about the belief of the traders, and the future price?
The opposite case would be that we entered the future contract at a price of $80/barrel, and now it is down to $72/barrel for the same contract. If we sold now, the seller would take a loss. This is known as "contango". What does this tell us, when we see something like this?
Now, here comes the thing that is really interesting...
If we were to go back five years, we could look at the "futures curve" to see if it was a normal market, or an "inverted market". What would it mean to us if it switched, from one to the other?
Another question is, if we went back five years, and started making charts of the actual future prices for every possible oil contract, and then plotted them against time up until today, what would each of those plots look like? If they sloped up? If they sloped down? What would this mean?
Perhaps there is little to gleen from the future prices, but I suspect that there is something in there that could be used as a predictor of the future of oil prices, as the consensus view in the market changes to one where Peak Oil constrains supply.
...
Here are a few more links about backwardation and contango. They seem to be the opposite of what I've said, which makes me wonder if they actually are, and if so, who is correct?
http://en.wikipedia.org/wiki/Contango
http://en.wikipedia.org/wiki/Backwardation
There are several possibilities for prices on the futures market. Let's look at a few in order...
1. The price of the contract is higher and higher, the farther the settlement date is in the future.
2. The price of the contract is lower and lower, the farther the settlement date is in the future.
3. The price is basically the same from now, all the way out.
4. The price of the contracts go up as you go to longer terms, and then come down somewhat.
5. The price of the contracts go down as you go out, and then start coming up.
Let's do some thought experiments on all of this.
What if the futures traders believed that the selling price (spot price) of a barrel of oil in December 2008 was going to be $100/barrel? It would make sense for them to purchase that contract. The more people that believed it would be that expensive, the more the price would go up. Each day, week, or month, the price of the December 2008 contract would be higher. Eventually, it would be $100/barrel.
What if the futures trader believe that the price would only be $30 per barrel. They would sell right now, in order to avoid losses. The more that believed it would go down to $30, the more would sell. Eventually, as we approached December 2008, the price would be down to $30.
So, the price right now reflects what is referred to as the "consensus view" of the price in December 2008. I believe this means that both buyers and sellers of that contract believe they are going to make money by buying or selling at that price. So, this could be thought of the halfway point between the most pessimistic view of the actual December 2008 price, and the most optimistic view, and all the views in between.
So what do all the possible scenarios that I listed above mean? The best article I've seen thus far is this one...
http://www.investopedia.com/articles/07/contango_backwardation.asp
This article describes that option 1 above, and perhaps option 4 are normal. The price for contracts further out are typically a bit more expensive than the current price. This is referred to as a "normal futures curve".
The article then describes option 2 and 5 as being "inverted market". Why would the price for later contracts be cheaper than now? Why would the futures traders "consensus view" be that the price in the future will be lower than now? Perhaps the price now is really high for a specific and temporary reason? This implies a shortage at the moment, which is or has driven up prices.
Option 3, the price being the same for a long way out, is extremely unlikely, particularly given inflation.
One interesting question is... If the futures price for the December 2008 delivery was 50% higher than the current price, what does that mean? Is there a huge surplus now? Or is there expected to be a big shortage later? Why would anyone buy something for a higher price that far out? Wouldn't they just buy it now, for the discounted rate, and store it until needed?
My understanding is that the current prices and the future contract prices are generally fairly close to one another. I suspect that as the price of one changes, so do the others.
NOW... not that the questions above have yet been examined in detail, but let us look at the prices in a different way.
Imagine that you had purchased that December 2008 contract for oil a year ago. At that time, the price was only $60/barrel. Since then, the price of that contract has been rising. It is now at $72/barrel. You have plotted the price of the December 2008 contract for the past year, and notice that the graph is sloping upwards. What does this mean?
According to the article linked above, this is called "backwardation". In other words, as time has passed, the price of that December 2008 contract has increased. What does this tell us about the belief of the traders, and the future price?
The opposite case would be that we entered the future contract at a price of $80/barrel, and now it is down to $72/barrel for the same contract. If we sold now, the seller would take a loss. This is known as "contango". What does this tell us, when we see something like this?
Now, here comes the thing that is really interesting...
If we were to go back five years, we could look at the "futures curve" to see if it was a normal market, or an "inverted market". What would it mean to us if it switched, from one to the other?
Another question is, if we went back five years, and started making charts of the actual future prices for every possible oil contract, and then plotted them against time up until today, what would each of those plots look like? If they sloped up? If they sloped down? What would this mean?
Perhaps there is little to gleen from the future prices, but I suspect that there is something in there that could be used as a predictor of the future of oil prices, as the consensus view in the market changes to one where Peak Oil constrains supply.
...
Here are a few more links about backwardation and contango. They seem to be the opposite of what I've said, which makes me wonder if they actually are, and if so, who is correct?
http://en.wikipedia.org/wiki/Contango
http://en.wikipedia.org/wiki/Backwardation