October 10, 2007
Speculation and fundamentals in oil prices
Knzn asks about the significance of the shift from contango to backwardation in the term structure of crude oil futures. I think one thing it signifies it that some OPEC spokesmen are simply blowing smoke.
Reuters reported last week:
More crude supply from OPEC would do little to ease $80 oil as speculative investment flowing into the market from other assets is boosting the price, Qatar's oil minister said on Monday....
"I am confident that the price is not related to supply," Qatar's Oil Minister Abdullah al-Attiyah told Reuters by telephone. "We increased at the last OPEC meeting and were confident that it would help the market, but unfortunately the market is moving in a different direction. More oil won't help at all."
To evaluate this claim, consider first what the market for oil would be like if there was never any speculation. The quantity demanded and quantity supplied would both be functions of the price, and equilibrium would require a price at which the two would be equal.
If speculators perceive that a higher price may be coming in the future, they might be able to profit by buying some oil for storage now and selling it at the higher price in the future. In this case, some of the oil that is being produced today would not go to satisfy current demand, but instead would be used to increase inventories. With less oil available to satisfy current users, the current price would be bid up. By this mechanism, the actions by speculators could cause the price to be higher than it would have been otherwise.
If the futures price (a price agreed to today at which oil will be purchased at some future date) is sufficiently above the current spot price (a situation described as contango), this can actually be a risk-free investment, as the speculator can sell any oil that goes into storage at a guaranteed high price. As discussed in the Wall Street Journal article noted by Knzn, the contango in oil futures markets last year provided a strong incentive for holding inventories. Over the last few months, however, the near-term oil futures price has risen more quickly than the farther out prices, moving us into the current situation of backwardation. In the current environment, anyone buying oil for speculation and selling forward at today's futures prices would in fact be locking in a loss.
Instead a more natural reading of the current situation is that the market is still anticipating the effects of the modest increase in Saudi oil production that has been promised as part of the recent increase in OPEC quotas. Assuming that arrives on schedule, it could start to bring some relief to oil markets. But until it does, prices will remain tight.
The real story remains as it has been-- the demand for oil remains strong, and increases in production have not been very significant. That reality is what has been driving oil markets all along.
Maybe you believe that the price of oil has nothing to do with the quantity of oil that OPEC produces. Or maybe you believe that the declarations of OPEC ministers sometimes have nothing to do with the facts.
Posted by James Hamilton at October 10, 2007 04:39 AMdigg this | reddit
Now I'm thinking the quotation almost makes sense if you read between the lines a little bit. The story goes something like this:
OPEC's normal policy is to tighten oil supplies so that the market remains in backwardation and OPEC retains control over spot prices. However, OPEC is willing to make an exception when they are convinced that oil prices are going to fall. And for a while, they were convinced, so for a couple of years, they produced at full capacity and kept spot prices down, attempting to take advantage of what they thought was a temporary price spike by selling as much as possible in the short run. But finally, as oil prices repeatedly failed to come down as predicted, OPEC threw up their hands and said, "We don't know what the heck is going on here, but obviously oil prices can stay high for a lot longer than we expected. We still don't believe that fundamentals justify such a high price, but apparently the fundamentals don't matter, so let's just go back to our usual policy."
Posted by: knzn at October 10, 2007 06:20 AM
OPEC members may also participate in the forward market, so your thinking has to include the fact that they (OPEC) can take advantage of opportunites there as well as producing for the spot market. Also, I think if you examine the number of open futures contracts for two years forward, it is about 1 day's worth of current production. There is no reason to expect that it is a driver of any significant producer's decisions.
Posted by: tinbox at October 10, 2007 07:55 AM
Here's another possible way to make sense of Mr. al-Attiyah's statement:
Consider the final words, "More oil won't help at all." This is equivalent to saying that oil demand is highly elastic, which, on the face of it, contradicts what everyone knows about short-run energy markets. But suppose something unusual is going on, causing oil demand to be highly elastic for the moment. That "something unusual" would be the presence of speculators with a fairly narrow confidence range around the price they are willing to pay for oil (or with strong support and resistance points). If we believe that those speculators operate using the distant futures (as seems fairly plausible to me), then the observed behavior of prices is consistent with the hypothesized behavior of speculators: when the price of 2-year-ahead oil futures threatened to go below $65/barrel, the speculators bought aggressively in spite of OPEC's attempts to undercut them; when the price threatened to go above $75/barrel, the speculators said, "Too rich for my blood" and sold off, despite the apparent tightness of spot supplies.
Posted by: knzn at October 10, 2007 07:58 AM
A couple of comments:
First, that graph from the WSJ is somewhat misleading by focusing on near term futures. Actually, the futures market has for several years been in a state of backwardation if you look at futures farther out than 18-24 months. What it has consistently shown is prices rising for 6-24 months, then falling for 4 to 6 years. Here is an example from as recently as June 7, 2007:
The recent change is that the short-term period of contango pricing has disappeared and we have only the down-sloping part of the curve.
My second point is that this has happened before, and it tends to happen when the spot price moves strongly upward. It seems that back end prices tend to move more slowly, and act similarly to a lagged moving average of front month prices. So when we have had a big upward move, as in the last few weeks, the back end lags and we have backwardation. When we have a big downward move, we have (short term) contango.
On this interpretation the current backwardation state is merely an artifact of the fact that the recent move upward has not yet made its way into back month prices. If we stay here long enough then we will see near-term futures (12-24 months) start to climb back above current levels while long-term futures climb much more slowly, and we will be back to a curve shape similar to the one in the link above.
Posted by: Hal at October 10, 2007 10:32 AM
Off topic --
Ladbrokes has Helpman and Grossman as best odds to win the Nobel in economics. That would mean a prize for addressing core economic questions, rather than finance or econometrics or whatnot.
Posted by: kharris at October 10, 2007 11:03 AM
knzn's theory of speculators buying at $65 and selling at $75 would be consistent also with airlines needing to lock in fuel costs. Airline fuel costs are now more than labor costs.
Posted by: akpundit at October 10, 2007 11:12 AM
Google 'convenience yield'.
Posted by: wcw at October 10, 2007 10:54 PM
when you produce oil, you have to store it if you don't consume it immediately. Suppose all storage tanks were full including supertankers. It would produce backwardation as was the case some years ago.
Posted by: 4degreesnorth at October 11, 2007 01:50 AM
Posted by: JDH at October 11, 2007 04:44 AM
My nobel nominations :
JDH for his crystal clear writing on hard topics
KNZN for being refreshingly different.
Posted by: Dr. Dan at October 11, 2007 05:32 AM
Do you still believe in the sentiments expressed in those early postings on peak oil, such as the one linked above, where you concluded:
"I still say that if you think peak oil already is here, there's some big money to be made."
Would you say that it is more reasonable to believe that today's high oil prices are due to fears of future shortages and beginning acceptance of Peak Oil theory? Or does backwardation argue against that?
Posted by: Hal at October 11, 2007 03:33 PM
Very astute questions as always, Hal. Yes, the backwardation is a problem for claiming that a drop in global production will arrive soon. On the other hand, since I made the statement you quoted, the spot price of oil has gone from $50 to $80 a barrel, and anybody who bet on Peak Oil at the time I wrote that has indeed made big money so far. I also note that the predictions of big increases in oil production such as that from CERA at the moment appear to have been wrong. There may be a loose interpretation of OPEC's behavior as choosing not to produce as much because of the scarcity option value, even if that is hard to reconcile with the backwardation.
If I had a fully satisfactory way to integrate all this, I would certainly spell it out clearly. The best I can do is admit that the information that has come in over the last two years looks to me to have provided more support for the claims that the peak in world production may not be too far off, and that such a claim is consistent with the realized time path of spot prices if not the term structure of futures.
Posted by: JDH at October 11, 2007 07:23 PM
Proving once again, JDH, that you are the most erudite economics professor out there.
Your constant attention to the oil situation is going to get you a serious cabinet position. Even HAL recognizes this eventuality. (IBM spelled backwards, one letter off).
But you still refuse to see reality.
You still confuse quotas with actual production. You got double faked. You went to an OPEC-10 standard (in your thinking). Even after you missed the All-Liquids strike.
First - See "Pitt the Elder"'s very recent posts on TOD. Very recent like last 3 or 4 days. I don't read that often, I just look for guys like Pitt.
I'm pretty sure you read TOD once in a while.
2) OPEC-12 is up almost 1 million bpd since January. Jan to Sept. OK. 900,000 barrels. I tried to run some comparisons between December and whatever, IEA, EIA. They didn't come out as good. Best I got was 500,000.
Doesn't matter. That is what the juice is my man.
We have to assume 500,000 barrels in either direction.
Have I ever given you my supply-chain spiel?
Oh, yeah. When you hear my supply-chain deal, you will finally realize that you know nothing about oil. And that I'm the funniest dude ever.
I'm trying to work it into a comedy routine. Jerry Seinfeld was never a science-guy. Obviously.
Posted by: CG at October 12, 2007 02:01 AM
chinese buying at $65 to fill their SPRs anyone ?
Posted by: markov180 at October 12, 2007 02:22 PM
This explanation doesn't work for me:
"Instead a more natural reading of the current situation is that the market is still anticipating the effects of the modest increase in Saudi oil production that has been promised as part of the recent increase in OPEC quotas. Assuming that arrives on schedule, it could start to bring some relief to oil markets."
at least from a US perspective, because nationwide inventories of crude haven't changed year-over-year. Whereas a year ago, you were getting paid to hold crude in inventory, today it's costing a fortune -- so I'd expect holders of inventory to be dumping crude IN ADVANCE of the extra Saudi production coming on market and because there's a negative return to hanging onto your inventory and hedging it in the futures market.
The only explanation I can come up with is that the rising tensions with Iran (the new premier and France are on board with more forceful US negotiations, for example) have convinced market participants to hang onto extra crude inventory as insurance against disruptions from the US bombing Iran.
I'll admit I don't find my explanation convincing, either.
I do know this - If I had any oil inventory, I'D BE SELLING NOW.
Posted by: Anarchus at October 12, 2007 07:04 PM
"The only explanation I can come up with"
This is the only explanation for why your mailbox isn't overflowing with offers from Mid East Oil sheiks and New York Banks.
Let me explain. If you had several other explanations, they wouldn't care either.
They only watch people like like me.
But I watch people like you. Keep trying.
Posted by: CG at October 14, 2007 02:27 AM
I think some of the story of the switch in oil futures is that some refining investments are going to start to come on stream in the next couple of years.
The crude futures are for light sweet crudes - easy to refine. The Refining industry is up against a hard conversion limit. So over the past couple of years, incremental production of heavy , high sulfur crudes couldn't produce any plus clean products, and the light sweet crudes commanded a premium. The futures market may be forecasting a reduction in the light / sweet premium, and refining margins, rather than a drop in the average price of crude.
All the incremental refinery projects I have seen any details about are based upon the heavy crudes. A lot of the expansions have a Saudi component - they seem willing to put up 25% of the cost in exchange for designing around incremental Arabian Heavy..
Posted by: dbr at October 14, 2007 06:31 AM