Oil Futures Suggest $60/Barrel Is Sustainable

Includes: OIH, USO
by: Marc Gerstein

Back on Sept. 27, we suggested that if oil prices were to fall to the mid-$50s, as some were predicting, such a level could "turn out just as fleeting as (the) recent peak in the mid-$70s." Since then, headlines trumpeting falling prices have alternated with those spotlighting upward movements. Ultimately, though, the futures markets continue to deliver the same message as in late September: Substantial and sustainable declines from current levels are unlikely.

Table A shows an observation we made in late September — that Wall Street's tendency to buy high and sell low — remains apt. Data collected by the Commodity Futures Trading Commission shows that investors (non-commercial traders) have been aggressively selling futures as prices fell while commercial traders, those with a good track record of buying low, have been adding to their positions.

Table A — Commitment of traders, net positions

Date Spot
Open futures contracts, net
Non-commercial Commercial
10/31/06 58.72 -11,311 18,354
9/26/06 60.63 13,685 2,756
8/15/06 72.95 83,794 -74,841
6/27/06 72.05 36,814 -24,116
3/28/06 65.65 7,218 2,810
1/3/06 63.11 -14,403 28,718
Commodity Futures Trading Commission data relating to light sweet crude futures traded on New York Mercantile Exchange

Tables B and C, with data as of Nov. 7, the last day before this writing when oil experienced a noteworthy weakness, shows that even then, much of the bearishness was confined to the spot market and the shortest-term futures contracts. Those locking in deliveries for December 2007 and beyond do not anticipate much in the way of further price declines.

Table B — oil % futures prices ($)

as of spot price Contract delivery dates
Dec. '06 Jun. '07 Dec. '07 Dec. '08 Dec. '09
11/7/06 56.61 57.72 63.65 66.30 66.45 65.40
9/30/06 62.90 64.15 67.83 69.00 68.46 66.79
6/30/06 73.94 76.12 76.32 75.42 72.97 71.17
3/31/06 66.25 69.67 69.82 69.40 68.20 67.20
12/30/05 61.06 64.01 64.26 63.59 61.99 60.49
9/30/05 66.21 64.01 64.26 63.59 62.48 61.38
Light sweet crude, traded on New York Mercantile Exchange

Table C — Prices for spot oil as well as the futures have dropped in the past four months, but the futures are up on the year.

Spot price Contract delivery dates
Jun. '07 Dec. '07 Dec. '08 Dec. '09
6/30/06 - 11/7/06 -23.4% -16.6% -11.4% -8.9% -8.1%
9/30/05 - 11/7/06 -14.5% -1.0% 5.0% 6.4% 6.6%
Oil futures based on light sweet crude traded on New York Mercantile Exchange

Table D shows the relationship between futures prices and the "fair values" for each contract based on adjustments for the time value of money, or the notion that a dollar three years hence is not valued the same way as a dollar today. In many instances, futures traded at discounts to fair value, a condition known as backwardation. Recently, though, we've seen more premiums which are known in the futures markets as contango.

Table D — oil, % futures price differentials from fair values

Based on
closing futures
prices as
of . . .
Contract delivery dates
Dec. '06 Jun. '07 Dec. '07 Dec. '08 Dec. '09
11/7/06 1.38 8.77 11.03 4.54 -2.62
9/30/06 0.81 3.71 2.63 -3.64 -11.02
6/30/06 0.37 -2.08 -5.87 -13.81 -20.44
3/31/06 1.14 -1.39 -4.65 -11.32 -17.30
12/31/05 -0.55 -2.87 -6.49 -13.74 -20.33
9/30/05 -9.54 -11.64 -14.94 -20.91 -26.46

Light sweet crude, traded on New York Mercantile Exchange
Fair value estimates exclude storage and insurance costs

Backwardation tends to occur when traders expect future supply to be great enough to prevent prices from remaining as high as they are at the present. That's the way the market perceived oil's prior rally into the upper $60s and $70s.

Contango occurs when currently perceived surpluses are not expected to persist. That's what futures markets seem to be saying about recent industry fundamentals.

The big question is whether futures markets are correct, particularly whether commercial traders will continue to get it right. We cannot predict whether they will remain so proficient, but it is noteworthy that for them, the stakes are much higher than for investors. Commercial traders need the commodity for the day-to-day operation of their businesses and cannot afford to simply exit the market in response to adverse price movements.

On reflection, though, it does seem that the futures markets have been rationally aligned with fundamentals.

The previous upward surge was associated with clearly perceived threats — the Iran nuclear crisis, tensions in Nigeria, and so forth. However, we can imply from the backwardation that the fears of imminent shortage, even if they had materialized (which they didn't), were not expected to persist long.

We can likewise infer from the contango we've started seeing that recent perceptions of surplus, if they materialize (the jury is still out), are not expected to last long.

Bottom line: while it's hard to pinpoint true equilibrium price levels, except perhaps in hindsight, it does seem likely that absent substantial new and sustainable changes in the supply-demand picture — major new discoveries and/or production capabilities, much more substantial deterioration on the geo-political front, and so forth — the equilibrium level is probably within a few dollars, one way or the other, of $60.

At the time of publication, Marc H. Gerstein did not own oil-related derivatives or stocks. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.