Understanding Long Term Oil Pricing

Here’s an email that asks a question other readers may also have:

Hi Jim,
I’m a regular reader of your site. I enjoy all the interesting articles that you compile and write about. I’ve read Profit from the Peak, View from the Top and all about oil megaprojects. What I don’t understand is why the oil futures, priced out all the way to 2016, could be trading for so little. If peak oil is really coming in a few years wouldn’t the futures market show some hint of it?   (think of all the big money involved, you would think some would go to studying future oil prices) But the market doesn’t. The market only gives Light Sweet Crude a 15% premium for delivery in 2016. http://www.nymex.com/lsco_fut_csf.aspx Help me understand why you think the market is so wrong.

thanks, Evan

Futures prices are tied to the spot price and each expiration date price of a futures contract is necessarily tied to the preceding expiration price.  That’s because if the price at a given date gets too far away from that at a nearby date an arbitrageur will buy the cheap one and sell the expensive one until the prices do become close enough.   So the curve is like a line that ties a boat to a dock.  The height of one piece of the line is controlled by the over-all shape of the  line and the shape can never get very steep. 

Longer term prices can be higher than spot, which is called contango or lower which is called backwardization.  They generally reflect traders’ opinions of the future direction of oil prices.  The current contago is seen to reflect positive long term expectations.  

Another way that long dated futures can reflect optimism or pessimism is in the pricing of put and call options on the longer dated futures.  Those premiums on calls were very small when I first started buying long dated calls in 2007.   They became much greater at the height of the recent oil price expansion.

I agree with the general premise of your question, that the current price of longer dated futures, especially 2011 - 2015, is going to look like a huge bargain by the time we get there.  The problem with simply buying a futures contract for delivery in, say, 2015 is that since it is tied to the spot price, it will decline if the spot price does and if it does decline you will have to post more collateral.  So it could become very expensive to just “hold on until we get there”.   

I sold all of my oil futures calls when oil was in the $130’s but unfortunately I then bought some back. My sense is that the price of oil still has further to fall during the current down draft.  I continue to own the calls I bought at higher prices and I intend to buy more at some point, but I am holding off for now.   My sense is that the best opportunity for buying more oil futures calls will be 6 - 12 months from here because it seems likely that the real economy will be undergoing substantial weakness for another year or two that will result in periods of general pessimism about the future price of oil.  That is when I want to load up on long dated calls.

Comments

[Ferdinand E...:]

Long dated futures! It seems like just yesterday I was telling my students and people at various conferences that long dated oil futures have no scientific meaning at all. In theory - and I guess in fact - the oil futures market has hardly any liquidity after about 6 months (or less), and so a contract out to 2016 is strictly a lottery. A lottery or worse, because as Jim Kingsdale points out, if something goes wrong during the time out to maturity (i.e. expiry), a lot more margin could be required.

But even so, better to be long than short in that market, depending on when you open a position.

2008 Oct 13 09:55 AM

[Joseph Wechter:]

I don't see a problem with buying long term oil futures contracts in this environment as long as you have some cash reserves to use for margin calls.

2008 Oct 13 11:02 AM

[fran:]

wouldn't the general investing public[unsophisticated... be better positioned on the future of energy using a form of rolling commodity index and energy stocks than fretting the questions involved with specific commodity futures and options and margins?

more didactic material of this nature is needed by much of the same investing public. it's good that you devote the column this way.

2008 Oct 13 01:06 PM

[Ferdinand E...:]

In the oil market, rolling short term positions over seems to have worked as long as backwardation prevailed. As for long term commitments, I just can't see the attraction of an illiquid 'market'. BUT, don't take my word. The best book on futures and options is John Hull, and I think that he will tell you the same thing.

2008 Oct 14 03:08 AM

[Peak Oil Ed...:]

It would be much more responsible to invest in alternative renewable energy (like nanosolar.com) at your home and voluntarily and systematically destroy our demand for oil as quickly and cheaply as we can. Waiting and betting on the failure of our energy supply chain is like taking out a life insurance policy on yourself. You are betting that you are going to die. This is not healthy speculation. Let's be a part of the solution instead of sitting around like vultures trying to profit off the problem. Where is the humanity?

2008 Oct 15 10:55 AM

[Ferdinand E...:]

'Peak oil educator', I think you mean WHERE IS THE SELF-INTEREST?
Obviously, it's a tremendous mistake to sit around and wait for the oil price to start escalating again, without supporting SOMEBODY'S comprehensive energy plan based on preventing a supply-chain meltdown. And.as you indicate, that is exactly what WE - i,e. the present generation - might be facing.

2008 Oct 16 03:45 AM