The Basis for Long Dated Oil Futures Prices

A major Street firm (actually, the one generally known as "The Smartest Guys in the Room") recently published a research report on oil containing the first discussion of the basis for long dated oil futures prices that I have ever read. I found it astounding.

I said in December, "The idea of being able to buy oil for only about $85 to deliver in five years, which is what the futures market is saying, is just bonkers." Given convincing evidence (at least to me) of likely supply and demand conditions that will apply in five years, it seems to me extremely unlikely that the price will not be multiples of that number. Well, here are smart guys saying that the price is related to the marginal cost of production.

Wow. The current price is about $97 - clearly based on supply and demand, not marginal production cost, but go out five years and suddenly the price is tied to production costs. Is supply and demand supposed to be repealed in five years? I must say, I just do not get it. I am betting real money that these guys - and the people who are doing the pricing in the futures pits - are simply wrong. Anyway, here is what the Smartest Guys said:

The impact of tighter short-term fundamentals on spot prices has been exacerbated by the continued increase in long-dated oil prices, which have soared to above $88.00/bbl, almost $20/bbl higher than last year’s average. As long-dated oil prices reflect the long run marginal cost of production [my emphasis]… the recent upward movement may once again be signaling the impact of escalating industry costs. While we maintain our current $80/bbl forecast for 5-year forward WTI prices, the continued strengthening of long-dated WTI prices amid ongoing cost inflation remains, in our opinion, the strongest upside risk to our forecast. Net, we maintain that the combination of tighter short-term fundamentals and escalating costs will continue to provide strong support to oil prices in 2008, with the risk skewed to the upside from current levels.

Comments

[E.D. Hart:]

I agree that it is ludicrous to contend that price is set over the long term by cost of production--if they maintain this for oil, it is also true for natural gas? Natural gas marginal costs of production vary widely, but supply and demand as it varies seasonaly explains 95% of price movement.

2008 Jan 07 03:35 PM

[Dave Marino...:]

The forward price of oil is not a prediction of where spot prices will be in five years, but the current price for oil to be delivered five years from now. Current prices are higher because tight supply/demand fundamentals for crude have placed a premium on prompt oil over oil for deferred delivery. Many factors set the price for long-dated oil -- expected production costs, economic growth predictions and interest rates, among others.

2008 Jan 14 11:22 AM