The Real Price of Crude Oil

Speaking at the San Francisco Money Show last week, I was asked on several occasions to explain why crude oil prices have doubled since the beginning of the year. Many investors wondered how oil prices could be near USD70 a barrel when US oil inventories remain seasonally high.

The first point to consider is your frame of reference for tracking oil prices. The simple fact is that oil prices never really traded below USD32 a barrel last December; although prices are certainly trending higher year to date, the gains aren’t quite as dramatic as many investors imagine.

The spot price of West Texas Intermediate (WTI) crude oil--the price of oil for immediate delivery--touched a low of USD31.41 a barrel on December 22, 2008. And near-month WTI futures contracts traded on NYMEX changed hands at around the same price in late December.

Television pundits often quote near-month futures or spot prices, but that doesn’t mean the spot price of oil is the most relevant for consumers and producers.

After all, oil producers don’t sell all of their production in the month of December and consumers don’t buy all their oil at one time of the year. What’s most relevant to producers and consumers is the average cost of oil over a longer period.

The purest measure of this “real” price is what’s known as the 12-month NYMEX Strip. There are oil futures contracts expiring in every month of the year for several years into the future. For at least the next year or two of futures there’s plenty of trading volume and liquidity.

To calculate the 12-month strip, we simply average the next 12 months’ worth of futures contracts.

Source: Bloomberg

This graph shows that the 12-month crude oil strip fell from around USD100 a barrel in September, briefly hitting lows of USD43 to USD45 in December and February. For the most part, the strip remained above USD50 a barrel, a far cry from that USD32 a barrel low in spot crude.

The strip has rallied roughly 50 percent this year from USD50 to USD75 a barrel--impressive but far less than the 130 percent rally in spot prices from USD32 to USD74.

What accounts for the discrepancy between near-month futures pricing and the strip? The simple answer: Record contango in the crude oil futures market.

Contango is a condition where near-month crude oil futures trade at a significant discount to crude oil futures several months into the future. The best way to illustrate contango is with a graph.

Source: Bloomberg

To generate this graph, I took the price of crude oil futures expiring 32 months in the future and subtracted the near-month futures price. Futures expiring 32 months from today represent the price you would pay today for crude oil to be delivered 32 months in the future (May 2013).

I plotted this graph over a trailing 10-year period. Over this timeframe, the average value for this spread was negative USD2.76 a barrel; in other words, long-dated crude oil futures generally have traded at a discount to near month futures. This is the opposite of contango, a condition known as backwardation.

A quick glance at this graph shows just how unusual market conditions were at the end of 2008 and early 2009. In late December, contango in the WTI futures market reached record levels, exceeding USD35 a barrel. Because spot prices were around USD40 a barrel at the time, contracts expiring a few years in the future were trading at a 100 percent premium to spot and near-month futures--a truly staggering figure.

Backwardation in the crude oil futures market typically indicates that oil market fundamentals are tight, but should ease in coming months. For example, after Hurricanes Katrina and Rita, near-month crude oil futures spiked as traders fretted over supply disruptions in the Gulf and damage to refining and transport infrastructure. There were some temporary shortages of crude and gasoline in certain markets because of pipeline and refinery closures.

At the same time, most traders expected conditions to ease once pipelines were inspected and brought back online. Thus, near month futures traded at high levels relative to longer term futures--the market was in backwardation.

Contango implies that near-term oil market fundamentals are bearish but investors still expect longer-term improvement. In the late 2008 through early 2009, investors faced rapidly rising US oil inventories and an accelerating decline in global oil demand--fundamentals looked bearish.

More important, the US and global credit markets were in a state of near-total dysfunction. The lack of demand, excess supply and near cessation of business activity due to weak credit market conditions pushed down near-month futures and sent contango to record levels.

Since early this year, contango in crude oil futures markets has declined to around USD8 a barrel, still a historically stretched level. The simple recovery in contango to more normal levels accounts for about USD27 a barrel of the USD31 a barrel rally in spot prices since the beginning of the year.

The above graph shows two other instances when crude oil market contango was high relative to historic norms: late 2001 through early 2002 and late 2006 through early 2007. On both occasions, near month oil futures rallied over the ensuing year, closing the contango condition.

In the case of 2002, near-month crude rallied from around USD22 to USD32 a barrel, eliminating the contango. And in 2007, crude rallied from around USD60 to near USD100 a barrel, closing the USD10 in contango that existed at the end of 2006. It’s hardly a big surprise that history is repeating itself: Near-month futures prices are on the rise, again bringing crude oil market contango back into line with historical norms.

Bottom line: The depressed crude oil prices at the end of 2008 and early 2009 were the real aberration--not the current quote. Those depressed prices reflected unusually weak near-term fundamentals and historic imbalances in the futures curve. Much of the subsequent rally has simply been an unwinding of those imbalances.

Comments

[Ivan Kitov:]

I agree that from the very beginning of 2008 oil price has been following a path, which might be called an unbalanced one. Striking feature of this path is that it repeats the trajectory of a pendulum - up-down-up ... Currently, it is the the middle of the upward motion (to the level around $100). One could expect another several months of this upward unbalanced motion. Then - down again.
In that sense, the unbalanced path is not an unpredictable one.
seekingalpha.com/artic...

Aug 27 09:33 AM

[Steve in TN:]

For residents of Europe the rise in oil prices is not nearly as steep as in the U.S. Corrected by currency levels, the current price of oil in Europe, in general, is around $61.

Aug 27 10:19 AM

[Steve in TN:]

I have reported abuse to the editor by the above poster who earlier went by the name of Cetin, and now "Rhodes Scholar" and 'MIT Mathematician". He is a spammer, posting the same message on every article during the day.
Please editor, permanently remove this guy!

Aug 27 11:00 AM

[Ferdinand E...:]

One thing my students must know if they prefer passing to failing: is that futures that go out longer than 6 months are not to be discussed in my presence. There is no or insufficient liquidity for those assets. In fact 6 months might be too much. And backwardation does NOT indicate that a tight market is going to ease in a few months. Maybe it will and maybe it wont.

But I really like the last paragraph in your article. It suggests that the article might be worth some serious study...if I could just forget that part about futures with a maturity of 3 years. By the way, Dr Bernanke once talked about the wonderful message he got from oil
futures with that maturity, and I thought that he had lost his mind.

Aug 27 11:44 AM

[4rdvark:]

It's not the price of the oil, it's the real price of the dollar. By that I don't mean the exchange rate, I mean how much hard stuff does it trade for.

Aug 27 02:25 PM

[Bob van der...:]

I follow the logic in your article as well as the plotting on your graphs and they are very impressive. But where in this article does it mention that supply and demand at the pump is what has been driving crude oil prices first down then up since last a year ago?

From an insider's to the petroleum industry perspective that is exactly what is happening now and will continue to happen in the absence of rampant market speculation in crude oil futures.

In a study published earlier this month Dr. Phil Verleger predicted that crude oil will get down to $20 a barrel by the end of this year. I am a little more optimistic and have posted an article on Seeking Alpha predicting $40 a barrel for WTI crude oil and under $2 per gallon pump price for gas by Thanksgiving.

Aug 27 02:25 PM

[Donald Ingram:]

The US gets most of it's oil supply from Canada and most of that comes from the oil sands where the cost of production is $60 to $70 USD per barrel. In the event of a down turn in oil to as much as $40 USD per barrel, the amount of oil exported to the US from Canada would suffer cut backs from the oil sands, instigating a short term shortage, which would then have the effect of driving up prices at the pump.


On Aug 27 02:25 PM Bob van der Valk wrote:

> I follow the logic in your article as well as the plotting on your
> graphs and they are very impressive. But where in this article does
> it mention that supply and demand at the pump is what has been driving
> crude oil prices first down then up since last a year ago?
>
> From an insider's to the petroleum industry perspective that is exactly
> what is happening now and will continue to happen in the absence
> of rampant market speculation in crude oil futures.
>
> In a study published earlier this month Dr. Phil Verleger predicted
> that crude oil will get down to $20 a barrel by the end of this year.
> I am a little more optimistic and have posted an article on Seeking
> Alpha predicting $40 a barrel for WTI crude oil and under $2 per
> gallon pump price for gas by Thanksgiving.

Aug 27 02:52 PM

[Elliott Gue:]

You are quite right; however, I do think the dollar/oil link has been overplayed in the media.

After all, gold is often considered the ultimate currency. Certainly, it has been accepted as money for more than 1,000 years and, therefore, has more legitimacy than the paper we call the US dollar.

At the beginning of 2009, a barrel of oil (based on WTI spot) cost 0.0506 ounces of gold. Now, that same barrel costs 0.076949 ounces of gold. Not saying the dollar is meaningless, just saying that not all of oil's advance is the weak dollar, there are other forces at play.


On Aug 27 10:19 AM Steve in TN wrote:

> For residents of Europe the rise in oil prices is not nearly as steep
> as in the U.S. Corrected by currency levels, the current price of
> oil in Europe, in general, is around $61.

Aug 27 09:10 PM

[Elliott Gue:]

While the articles concerning $20 or $40 oil referenced in the comment above contain some interesting points, I would be willing to take the other side of that bet. I am looking for oil to top $100/bbl in 2010 and possibly even challenge those '08 highs in coming years.

Your comment makes a completely valid point. Basically, at $20 or $40, much of the world's production isn't economic. As global oil demand returns in coming months, the important point to consider is really what is the marginal cost of oil? In other words, what does it cost to bring an incremental barrel into production to meet demand. Reserves like the oil sands and perhaps deepwater would represent marginal barrels -- if production is to actually increase, exploiting these marginal barrels needs to be profitable.

In its recent conference call Schlumberger (NYSE: SLB) made some interesting comments in this regard. It seems that the company believes oil prices will need to be around $70 at year end if production firms are going to have enough confidence to increase their capital spending budgets. At $40 they'd slash CAPEX plans and global oil production would fall off quickly. And if oil prices look to be too volatile they may also be reluctant to boost CAPEX.

There is a very real risk that in 2010, the CAPEX cutbacks of late 2008, early 2009 will come home to roost in the form of falling production just as global demand re-accelerates. Then, you have the recipe for a real spike.


On Aug 27 02:52 PM Donald Ingram wrote:

> The US gets most of it's oil supply from Canada and most of that
> comes from the oil sands where the cost of production is $60 to $70
> USD per barrel. In the event of a down turn in oil to as much as
> $40 USD per barrel, the amount of oil exported to the US from Canada
> would suffer cut backs from the oil sands, instigating a short term
> shortage, which would then have the effect of driving up prices at
> the pump.

Aug 27 09:22 PM

[Moon Kil Woong:]

Actually, I believe the biggest discrepancy as to why that near term oil trades at a discount is because actually with slack demand and record inventory, no one actually wants delivery, however, they want the option to get access to it should supplies every tighten. Thus in some ways it's like a form of insurance.

Of course, others play it like insurance against dollar depreciation and a run on commodities should inflation show up. To each their own reasons to play this market. All I know is it's starting to get to be a headache for refineries and buyers to find places to store the growing backup of already pumped oil.

Aug 27 11:35 PM

[A Barrel Full:]

I second the idea that the last paragraph is the most important.

Commentary concerning the rise from below $40 ignore the fact that $40 itself was an anomaly

Aug 28 05:03 AM

[specks:]

Phil Erlager, professor out of U of Calgary, says we are short term out of storage and, with use declining, there will be no place to store crude. We are out of storage space, apparently, and with seasonal price declines, the rate of price decline will accelerate.
How many ships off-shore??
I don't know!

Aug 28 01:30 PM

[Ferdinand E...:]

Specks, I think his name is Verleger, and he don't know nothin' at all.

However, that isn't important. What is important is that thousands of people who have studied finacial economics know so _____ little about the futures market.

Aug 29 08:59 AM

[Tony Daltorio:]

The key point in the article is at the end when the author points out that those prices near $30 per bbl on the NYMEX were an aberration.

And I believe an outright manipulation to the downside by the Wall Street 'boyz', but it will never be investigated since falling oil prices are "good'.

Aug 29 03:28 PM

[smarttogether:]

I live in Alberta, home of the oil sands, and I'm not sure where the quoted cost of $60 to $70 dollars a barrel to produce oil from tar sands came from. The highest cost I could find was $36 to $40 dollars for a new mine, and about half that for an existing mine - info found in Wikepedia.

Aug 30 03:20 AM

[Danny Furman:]

$60-70 is likely the price that firms with exposure to the sands require to operate. Extraction costs in Africa & the Middle East are often under $10. Global demand is increasing and will continue to for years. Sustained sub $50 oil would seemingly require a near double in the USD.


On Aug 30 03:20 AM smarttogether wrote:

> I live in Alberta, home of the oil sands, and I'm not sure where
> the quoted cost of $60 to $70 dollars a barrel to produce oil from
> tar sands came from. The highest cost I could find was $36 to $40
> dollars for a new mine, and about half that for an existing mine
> - info found in Wikepedia.

Aug 30 09:52 AM