Economics of Oil Futures Trading, Part I

Politicians seem to generally dislike high prices (except maybe when they're selling their own houses or their own stocks) and are quick to conduct investigations or propose legislation any time they feel that prices are "too high."

If market-driven CEO compensation is high and rising because super-star executive talent is scarce relative to the demand, politicians generally condemn the high salaries. If market prices for plywood or generators rise after a hurricane because of increased scarcity, politicians condemn "price gougers" and sometimes put them in jail. When gas prices rose after 9-11 and after Hurricanes Rita and Katrina in response to significant disruptions in market conditions, politicians investigated oil companies and gas stations for "price gouging."

If rents in NYC or Berkeley are rising due to increasing demand for rental housing interacting with a limited supply, politicians have passed "rent control" legislation.

In the most recent period of high and rising oil prices, there's a new bogeyman on the block, coming under the watchful eye of politicians: SPECULATORS. In their perpetual mistrust of market forces, politicians cannot accept that high prices might actually be a result of either rising market demand, or falling market supply, or both. And there seems to be a general misunderstanding among both politicians and the general public about the basics of futures of markets in general, and the relationship between spot prices and futures prices in particular. Consider that:

Spot Price + Carrying Cost = Futures Price

For a one-year period for oil it would be:

Spot Price of Oil Today + Carrying Cost of Oil for One Year = Futures Price of Oil for Delivery in One Year,

where the carrying cost includes storing oil for one year, and the opportunity cost of $100 of capital invested today to buy oil at the spot price (foregone interest for one year). Assuming the carrying cost of oil is $5 per barrel per year, and a spot price of $100 per barrel, we would have a futures price of $105 per barrel:

$100 Spot Price per barrel + $5 Carrying Cost Per Barrel = $105 Futures Price.

Assuming that the $5 carrying cost remains fixed in the short run, we can see that there is a direct one-to-one relationship between the spot price and the futures price, and if the futures price rises, the spot price would rise by about the same amount. And that 1:1 relationship would exist even if speculators were banned from the market, and only hedgers remained to trade.

For example, assume that Northwest Airlines (NWA) and other carriers anticipated that rising global demand for oil and tightening oil supplies would put upward pressure on oil prices for delivery in June 2009. To hedge against the price risk of higher oil prices, NWA and other transportation companies that rely on oil as a major input might start buying oil futures contracts for delivery in one year, which would put upward pressure on the future price of oil, say to $110 per barrel. Now the relationship would be:

$100 Spot Price + $5 Carrying Cost < $110 Futures Price.

At the spot price of $100 per barrel, arbitrage profit opportunities would exist. You could buy oil today at the spot price of $100 and simultaneously sell contracts at the futures price of $110. After adjusting for the $5 carrying cost, you would have a $5 profit per barrel. But others would join you in your money-making plan, and the rising demand for spot oil would raise the price to $105 per barrel, such that:

$105 + $5 Carrying Cost = $110 Futures Price.

Notice that the spot price went up when the futures price went up, due to the trading of hedgers like NWA, and this would happen EVEN IF THERE WERE NO speculators in the market.

Conclusion #1: Spot prices generally rise (fall) when futures price rise (fall), due to market forces today and anticipated market forces in one year.

Conclusion #2: Conclusion #1 holds even when ONLY hedgers participate in a futures market.

There is a straightforward, mechanical relationship between spot prices and futures prices that doesn't necessarily have anything to do with speculators. In fact, speculators don't determine market forces, they respond to market forces of supply and demand.

Therefore, speculators can't be blamed for high oil prices, because high oil prices are ultimately caused by factors beyond the control of any speculator: rising global demand in places like India and China, and global supply in places like Saudi Arabia, Nigeria and Venezuela. No individual speculator, nor any group of speculators, has an iota of influence over the demand for gas or oil in Brazil, nor do they have one iota of influence over the amount of oil in Canada or ANWR, or any control over OPEC quotas.

Think about it - Exxon Mobil (XOM), one of the largest oil producers and private oil companies in the world, has NO control over the world spot price of oil, so how could a small group of speculators?

Part II follows.

Comments

[fxtrader07]

'If market-driven CEO compensation is high and rising because super-star executive talent is scarce relative to the demand...'

since when are these insane compensation schemes market-driven? they are not! they are simply based on the relative power od companies' boards and mgmts that allow them to fill their pockets almost as much as they want at the expense ofthe ordinary shareholder.

'spuerstar-executive talent'? you mean that 'talent' of Prince, O'Neill, Sullivan, Rohner, Dillon, Nardelli... - to just name a few who got paid hundreds of millions for destroying billions of shareholder value and even getting dozens of millions just for leaving the company? that kind of 'market-driven' salary for 'scarce executive talent' ?
Give me a break!

[fxtrader07]

your article is absolute crap, really! You claim a PhD but you obviously have no clue about futures and commodities markets. And given your recent articles on economic matters (inflation, unemployment) thze same applies to general economics.
it is easy to talk in abstract terms about 'rising demand' and 'diminishing supplies' but when these are cited to prove something like causes for price movements one would think that a PhD couid come up with real, hard numbers and facts.
the same applies to the numbers behind money inflows into commodities markets. you simply ignore them - and then you call the article 'economics of oil futures'
I rest my case

[chistletoe]

Congress, of course, had nothing to do with the terribly shortsighted and ignorant decision to convert corn into fuel on a massive basis, or the decision 20 years to make heavy excise taxes on automobiles but exempt SUV's, or the many decisions to tear down railroads and build highways, or to continue to fund the fiasco in Iraq ...

[Indyphil]

I look forward to part II. Thanks for posting this article. I have read some of your others and I got the impression before that you didnt believe in the fundamentals driving the oil market. Perhaps I mis-understood.

Perhaps the question to address is not so much the overall relationship between futures and market fundamentals, but how much volatility the speculators bring to the table. Does less trading volume = slower changes and less "noise".

[freefall51]

I am confused about this article, in particular the meaning of carrying cost. If I had to make a call and lock in the price of say two years out I can reasonably assume, that the oil is not there yet. I the oil were to be delivered just in time from the well into my tank the carrying cost are zero.

Just yesterday I read something elsewhere in SA that was much more logical to me. Lets assume the spot price today is $100 per barrel and I want to lock it in for two years. I have to put up earnest money (I hear 8 % of the contract = $ 8/ barrel) to have this call option. I have to finance my downpayment for two years. I do this with my credit card on the basis of 15 %/yr. So without compounding interest this is 30% of $ 8 for two years or $ 2.40/ barrel.

If I lock in cost $ 100/ barrel, the future price shall not exceed

($100 - $2.40)/ barrel = $ 97.60/ barrel. That is called backwardation and is supposed to the normal way the market works. If we get contango the market assumes that the price of oil exceeds the present spot price.

Right or wrong?




in any tank yet. and the oil will and twere

[freefall51]

Sorry about these typos in my earlier message. I am really bad reading from the screen.

[800LBGORILLA]

Keeping it real.Good article.

[Brian27]

If the spot price of oil is $100 and interest rate 8% per annum the carrying cost of a barrel of oil for two years is $16 plus the physical storage cost of the barrel.

Assume the storage cost is $1 over two years. This results in a futures price of $117 for a barrel of oil two years in the future.

Suppose that the actual future price is $114 then the arbitrageur will borrow a barrel of oil and sell at the spot price of $100 (short sale) and buy a barrel of oil in the future at $114. In two years the arbitrageur pays $114 for a barrel of oil and returns it to the lender plus $16 interest and $1 storage. Which results in a riskless profit of $3.00. Buying spot short and long future will continue until riskless profits are zero.

Suppose that the actual future price is $120 then the arbitrageur will buy a barrel of oil at the spot price of $100 and sell a barrel in the future at $120. In two years the arbitragur delivers the barrel of oil to fulfil the future contract. The riskless profit after paying $16 interest and $1 storage is $3.00. Buying spot long and short future will continue until riskless profits are zero.

[jjason]

Mark Perry, this article is not true. I agree with fxtrader07.

Read two articles on SeekingAlpha, Dr. Perry:

1. Phil Davis explains "paper oil"...meaning oil futures contracts that are sold without the intention of ever taking delivery of the oil. Speculators are buying contracts for oil that far exceed the supply of oil available.

2. Anthony Schneider explains how oil price manipulation is done by I -Banks, hedge funds and others using ICE, NYMEX and other exchanges. The CFTC has been complicit in all of this fraud against the public.

I would suggest to SeekingAlpha readers to search the articles I have mentioned and also :

commerce.senate.gov/pu...

The above link ( I hope ) will take you to a pdf file so you can read Professor Michael Greenberger's report that was given on June 3 2008 to the US Senate Committee titled "Energy Market Manipulation and Federal Enforcement Regimes".

The US Congress should do more, faster to force the FTC, CFTC and the FERC to do their jobs to protect the public from being deceived and cheated.

If you have any concept of honesty, Dr. Perry, you will read these articles and Professor Greenberger's report and write the truth about what is happening in commodities futures trading.

[jjason]

The link has not been properly posted by SA in my comments.

Here is the info without http://

commerce.senate.gov/pu...

If you go to the US Senate site and put in the above into the search box, you will get the article by Prof Greenberger.

[jjason]

Sorry. Maybe someone could tell me how to post a link that will work.

[Gary Lucido]

Mark Perry is absolutely right. The bottom line is that unless speculators are taking physical delivery they can't impact the spot price. Seems pretty obvious to me. I make the case here:
www.investingminds.com...

[jjason]

Gary, Did you read the report by Michael Greenberger?

I figured out how to post the link properly.

GO TO

www.commerce.senate.go...

[Sophisse]

I read the report. I couldn't get past all the inter alia's though.

[jjason]

Professor Greenberger's report is not easy reading.

A harder read is the 292 page report the was given to Senator Joseph Lieberman's committee in 2003. On this committee were Senator Stevens, AK., Collins, Me., and about 20 other Senators. Nothing was done to correct the "Enron Loophole".

Another good article is:

www.star-telegram.com/...

I want to see honesty in reporting and honesty from Congress, President Bush, I-Banks, brokers and others in the investment community. Don't you?

[Gary Lucido]

The Michael Greenberger report is pretty long so I skimmed through it. Looks like he makes a bunch of unsubstantiated claims that manipulation is occurring and he references other's claims but I'm not hearing anyone explain the mechanism by which speculators impact the spot price of oil without taking delivery.

[Brian27]

Greenberger report is just unsubstantiated speculation. The Masters report explains the mechanism.

hsgac.senate.gov/publi...

His argument is that the managed funds allocate a percentage of their portfolios to commodity futures indexes. This increases future prices and by arbitrage spot prices. To quote Masters

"There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.

It is easy to see now that traditional policy measures will not work to correct the problem created by Index Speculators, whose allocation decisions are made with little regard for the supply and demand fundamentals in the physical commodity markets. If OPEC supplies the markets with more oil, it will have little affect on Index Speculator demand for oil futures. If Americans reduce their demand through conservation measures like carpooling and using public transportation, it will have little affect on Institutional Investor demand for commodities futures.

Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits. "

Index speculators maintain the dollar value of their positions, rolling over at expiry, without regard to expectations about future prices. That means they can take unlimited losses if future prices fall.

Futures investing without expectations of future prices appears to be a recipe for disaster since other market participants (traditional speculators and risk hedgers) will take positions based on price expectations. So if supply is increased or demand decreases hedgers and traditional speculators can inflict huge losses on the indexers by short selling. How long will that last before the index speculators are done?

Another problem with the Masters argument is that their is no physical delivery of the product to index speculators. They are not buying up scare resources for profit. If they were they would have to store it or sell it into the market to recoup their costs.

[RebelTrade]

Well put. This is exactly how my professors taught me that the market works. The Futures are the most democratic forum ever invented since the price represents and reacts to the sum of all the trader's expectations and decisions. Both Bulls and Bears.

Simply put, if one thinks that the pricing is wrong, place your vote by putting your money where your mouth is.

[King ofSanity]

I cannot see any justification for the price of oil whether it be instant riches for speculators or CEO's needing to buy an extra chalet or two in Aspen. One day we hear that there is a shortage in supply due an ongoing ever increasing demand that is driving the price through the roof. The next day we hear that demand is down in the US, but China and India's demand offsets any drop in US demand. Then the next day we hear that although demand is down in the large industrialized countries, refineries do not have the storage capacity for increased supply thus creating a shortage of supply. It sounds like if one excuse is spot lighted, another pops up in attempt to justifiy the high prices. It sounds like when you catch a child in the act of doing something wrong, they instantly come up with another excuse to stay out of trouble. I hope that OPEC and the Saudi's flood the market to the point where the bottom falls out to the tune of $40.00 for a barrel of crude and all of the greedy speculators get burned to the point to where they will keep a safe distance from bidding on oil futures for a long, long time.

[AEB]

As Checkhov said (who was an MD in addition to being a writer), "When many cures are offered for a disease, it means the disease is not curable."

I have read endless debates about whether or not futures speculation on oil is a big problem, a small problem or not a problem. There are many credible arguments that support each position.

The disease is not curable.

I think that everyone needs to get over this issue about speculation, and focus on the real supply and demand issues that underlie oil and gas prices. If there were no imbalance, no one would speculate because there would not be the possibility of profit.

People will hedge, speculate, invest, cheat, and complain until the game is over, and they move on to the next game where money can be made.

What will legislation address? Who specifically is to blame? Name some names, not broad groups of faceless people like index funds. Are you sure that your portfolio doesn't contain index funds? Are we our own enemy?

There is no cure for this symptom.

[erub]

With proper regulation the market place is a very democratic forum. But we don't have proper regulation of our markets in the U.S. or in may EU markets. That's why the business cycle has been largely replaced with the bubble-cycle.

Fundamentals of supply and demand effect the market over the long run but spikes such as we've seen in real estate and commodities more recently are results of massive amounts of liquidity being poured into a sector, in spite of the fundamentals. The free movement of these pools of capital into markets and sectors worldwide (like lemmings or locust, have your pick) are destabilizing for both the U.S. and world economy. Hedge funds are huge for a reason - they make money on both the ups and downs of markets. Conveniently, they profit from and are a major cause of the volatility as we commoners continue to have our pockets picked.

[AEB]

Erub makes a good point about the bubble cycle, though I am not certain that poor regulation of markets is either the cause or the solution. It seems more likely that absurdly low interest rates encourage migration of investment into whatever sector offers the lowest risk profit.

[jjason]

Some of you get it and some of you don't.

Those folks who did not get out in time have lost money in the busting of the housing bubble. The folks who own their homes with reasonable debt will just have to wait, maybe six more years to have a profit on their personal residence.

In the meantime, I hope oil prices go down and cause horrible losses for the "momentum" traders and the commodity speculators.

[what do iknow]

governments role: leave it alone

if the 'hedge funds' or whatever else you deem responsible for this unreasonable price of oil are behind high oil prices, why are there riots in Spain, India and China?

Furthermore if we (US Gov.) pass legislation restricting the market and speculation within the market, this is only valid on US soil. What makes you think for 1 second that other countries won't fill the void.
No sooner than the passing of this said legislation our US hedge funds would be immediately setting up sister companies on foreign soil to resume trading.

you either believe in a free market or not. The same hedge funds that went belly up with the housing boom will likewise do the same when the oil bubble bursts (As it will).

I would be interested in your differentiation of speculators and future buyers as both are in for their own interests... making money or preserving margin on future revenues.

you want to burst the oil bubble? Do it. Drill, explore explore new technology and implement. Speculators will have little foothold on a 'volatile' oil market when the threat of a rouge terrorist nation is eliminated via the US becoming self sufficient.

Don't fool yourself though. Just as soon as we become self sufficient and realize our potential of supplying oil to the world the private companies that had the stones to invest in exploration will look to be compensated fairly for their share of the kill. As they should. But THIS amount of 'newly delivered' supply will not be near as volatile or subject to sharp speculation as the status quo.

Lastly since day one in our economy there has been 2 components
supply, demand... with that there has been companies buying futures or speculating on the price of futures. Prior to 2005 we were okay with the way the market worked. However if speculators were really the big bad wolf, why were prices acceptable then. How can you blame the speculators and turn a blind eye to the growth of both China and India?


And who are you to say that the prices are too high? And tell me... when did they get there?