Oil futures and the future of oil

Commodity traders can have as hard a time as any of us trying to predict oil prices. But
it’s interesting to see what the current price structure tells us about what traders believe
brought about the current high prices and what may be in store for us next.

One can enter into an agreement, brokered through the href="http://www.nymex.com/index.aspx"> New York Mercantile Exchange, to sell 1000
barrels of oil some time in July at a price agreed to today, an agreement described as the July
2005 futures contract. Actually, it’s been possible to write July 2005 futures contracts for a
year and a half, locking in the delivery price way in advance. For example, you could have
found someone in January of this year willing to sell a July 2005 futures contract for $42 a
barrel, which, had you been on the buying side of the deal, would have left you sitting pretty
today. You’d be picking up 1000 barrels in a few weeks for $42 each, and could sell them right
away for immediate delivery to somebody else on what’s called the “spot” market for likely over
$52 a barrel, earning yourself $10,000 profit on each contract you purchased.

Of course, the person on the selling side last January of the July 2005 contract would be
none too happy about it today. Had they known in January how things were actually going to turn
out, they never would have agreed to the deal. Most likely the other party to the deal expected
oil today to be selling for about $42 a barrel, and was quite surprised (not to mention greatly
annoyed) to see it go over $50.

Some oil suppliers may have wanted to hedge away any downside risks, and have been willing to
sell a July futures contract for $42 last January even though they expected the July spot price
to be $44, thus guaranteeing themselves an adequate margin. Alternatively, some buyers (such as
airlines) might have wanted to buy a contract for $42 even if they expected the price to be $40,
to insure themselves against any risk of big losses on fuel costs. But for each of these
hedgers, there are plenty of speculators more than happy to take the other side of the deal if
the speculator expects to make a profit. For this reason, the forces of supply and demand
usually drive the futures price to a consensus value as to where traders expect spot oil prices
to go in the future.

historical_and_future.gif

As of today, one could write not only a July 2005 futures contract, but a contract for
delivery of oil as far ahead as December 2011. The prices of a set of such contracts can be
viewed daily at TFC Commodity Charts
. For example, the July 2005 contract traded today for $54.28, the December 2005 contract
for $57.58, and the December 2006 contract for $56.93, suggesting that the market is betting on
oil prices to continue to increase through the rest of the year but then to start coming back
down. The graph at the right shows the historical path of spot oil prices up through today
along with the projected path of oil prices from here on that is implied by today’s futures
prices.

One possibility that has run through many of our minds is whether the oil price run-up over
the last two years might be the first signs of an inevitable eventual decline in annual global
petroleum production resulting from exhaustion of the world’s oil fields.

Energy Outlook
, Daily Kos,
Angry Economist
, and
WhirledView
, to pick a random selection, have discussed this, and indeed there are entire
blogs (e.g., href="http://theoildrum.blogspot.com/2005/06/would-that-peaking-were-so-transient.html"> The Oil
Drum ) and metadirectories like Hubbert Peak and
The Dry Dipstick devoted to this theme.

If this were the concern motivating today’s oil buyers and sellers, however, we would not be
seeing a projection of declining oil prices going into the future but instead a rising price
path reflecting investors’ understanding that oil would be becoming an increasingly scarce and
valuable resource in the years ahead, according to the principles first articulated by Hotelling
in 1931 (see for example
Brown and Wolk, 2001
). It also is hard to square with the fact that we observed a href="http://www.econbrowser.com/archives/2005/06/whats_up_with_o.html"> dramatic acceleration
rather than deceleration in global petroleum production in 2004.

The pattern in the futures prices instead suggests that the consensus opinion on the part of
commodity speculators is that we are going to see either supply increases or demand decreases a
year or two down the road. Optimism about Iraq I suppose is one scenario that might be used to
motivate the first view. But I’m inclined instead to look for developments coming on the demand
side.

Energy users anywhere in the world are going to respond to the incentives brought about by
higher prices, changing their daily methods of transportation and production when it becomes
apparent that the old way of doing things has become too expensive. But making these changes
takes time. For example, you don’t throw out your old car, but when it comes time to buy
something new, most people will worry more about fuel efficiency when they’re paying $3 a gallon
for gas than they did when it was $1.50. It seems particularly likely that China, whose
burgeoning demand has been driving oil prices up these last two years, will find ways to make
some needed adjustments in the near future; href="http://energyoutlook.blogspot.com/2005/06/wasteful-china-americans-get-lot-of.html">
Energy Outlook has some interesting analysis on this possibility.

None of which is to say that the peak oilers have it wrong. Indeed, given enough time,
they’re bound to be right, as oil production can’t geologically continue to increase every year
forever. And certainly commodity traders can make mistakes, as the poor folks who sold the $42
July 2005 futures back in January found out, and perhaps those promising today to sell oil for
$55 in 2009 will discover a few years down the road. But what does seem apparent is that the
concerns of the peak oilers are not the same as the concerns of those currently willing to cut
trades on the NYMEX. And if the former are persuaded that the latter have it all wrong, my
advice is, rather than try to educate the ignorant, settle for taking their money. But watch
out. Those capitalists might be sharper than you think.

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28 thoughts on “Oil futures and the future of oil

  1. New Economist

    James Hamilton joins the blogosphere

    It is always a pleasure to come across a new econoblogger of worth. A hearty welcome to James D Hamilton, Professor of Economics at the University of California at San Diego, who has just joined the blogosphere. So far his Econbrowser blog has covered …

  2. TRE

    For completeness, a chart of spot prices versus projected (futures) prices would indicate just how prescient our futures traders are. I suspect we would find that their predictive powers are appreciably lacking at key times, particularly when fundamentals change (e.g. production constraints).
    Also, it’s important to note that the projected price decrease is not significant. If I remember correctly, futures markets were telling us a year ago that oil now would be much much cheaper. Now they’ve jumped on the tight-supplies bandwagon and are telling that the price will pretty much be–what it is today.
    In summary, I’m not sure the futures market is telling us much of interest.

  3. JDH

    I agree with TRE that futures markets don’t reliably tell us for sure what’s going to happen. But they do reliably tell us what the market thinks is going to happen. And those perceptions are what I intended to call attention to with my post.

  4. theCoach

    What would be a good indicator of the certinty of the futures traders?
    volume, volatility? is there a good way to measure how confident that consensus market price is?

  5. anne

    Dear James Hamilton:
    Yes; I would surely like to read your fine blog but the type size is just too small to read comfortably. Could you please increase the size. Brad DeLong’s type size is perfect. Also, the type seems faint but this too may be due to the small size.

  6. no name

    In firefox, one can hit CTRL and the + key simultaneously to increase font size (CTRL and – simultaneously to decrease font size). Under the View menu, go to Page Style and choose No Style, if you wish to get black font, but I think that once you CTRL+ a couple of times, the readability will be fine.

  7. JDH

    To measure how uncertain traders are about the forecast path, Coach, one would want to look at options rather than futures prices. You can get current values of the volatilities implied by options prices from http://www.mrci.com/client/options/volatility.asp. Whereas there’s nothing to calculating the implied mean from futures prices, calculating the implied volatility from options prices is a bit more involved.

  8. anne

    Thank you so much, but I can not be adjusting my computers for each site and tech has set up Explorer for me. I would have hoped the size of type could be made larger so I could read along. As I am always sure to accomodate all in lectures or seminars, so I at times need to be accomodated. Alas.

  9. quixote

    Anne: there are many blog sites where small type is a blessing. (The smaller the better, if fact.) However, I agree with you that econbrowser is not one of them. Actually, it’s equally simple in Explorer to increase type size. (On the top menu bar go to View–>Text Size–> and select your preferred size.) The preference is retained for other web sites and for the next time you use the browser, but it is rather simple to change, and does offer a workaround. (Some sites are written in such a way that the reader can’t control type size, so this tip won’t always work.)

  10. JDH

    OK, Anne, thanks to your persistence, I figured out how to change the fonts. If you’re still hanging around, feel free to quarrel with the content in addition to the style.

  11. anne

    Ah, thank you James Hamilton. Content it is from here; after a rest from friends who are all about. Of course, I rather like this essay. That was nice of you, and I do think necessary :)

  12. James Wimberley

    Market data is also available for the comparatively small (just under 1GW/year) but rapidly growing (about 25% per annum) photovoltaic solar panel market. Prices for PV have been rising recently, since autumn 2004, see table at http://www.solarbuzz.com/moduleprices.htm and chart on the home page. But demand continues to rise smoothly, see http://www.solarbuzz.com/StatsGrowth.htm and penultimate chart on http://www.epia.org/03DataFigures/DataWorld.htm.
    1. Solar energy producers must be making temporary superprofits, as it’s hardly possible that real production costs are rising for a technology based on silicon as raw material and semiconductor physics as the knowledge base.
    2. Solar energy consumers (no longer a few oddballs motivated by idealism not economic rationality) believe that non-renewable energy costs will at least stay high in the immediate future, and/or that the risk of supply disruptions is real.
    3. The rapid growth in demand, against a still higher cost in $ per watt, suggests that the main driver is risk management.
    4. The US is a bit player in the global PV market.

  13. Brad DeLong's Website

    James Hamilton from UCSD Joins the Party…

    He is incredibly smart and incredibly hard working: we eagerly look forward to lots of refreshments: Econbrowser: June 09, 2005 Oil futures and the future of oil Commodity traders can have as hard a time as any of us trying to predict oil prices. But i…

  14. matt wilbert

    I believe that the production process of PV cells requires quite a bit of energy, as well as other resource inputs like copper, so there is no reason to think that PV production costs are not rising.
    Let me stress that I don’t have any idea what is actually happening to those costs. I hope the producers are nicely profitable.

  15. haraldb

    tap the brakes money, your speeding. Or in other words I’m confused.
    Don’t oil futures behave more or less like financial futures?? Pricing is based on spot prices plus cost of carry. If markets believe oil in the future will become scarce and bid up futures prices, won’t arbitragers borrow money, purchase oil spot, short the overly expensive contract, and deliver in the future for a risk free profit??
    Doesn’t theory suggest that todays spot prices reflect all information regarding current and future oil availability?
    Or did I just waste two years at graduate school?

  16. JDH

    I won’t comment on whether graduate school was a waste or not, harldb, but you’re exactly right about the arbitrage. The peak oilers are claiming that an episode of falling global oil production is just around the corner. That scenario is flatly inconsistent with the prediction that oil prices are going to decline over the next five years. If you think that the peak oilers are right, then you have to believe that the market is wrong. What you should be doing right now in that case is buying oil futures. Or, if you believe the market, the peak oilers are wrong. They can’t both be right– that’s my point.

  17. Andres

    Part of the problem with forecasting oil prices is that there is a dearth of good data. We know fairly well the situation of private, listed energy firms. It’s not very encouraging. Despite gushing cash, their production levels are barely growing and their reserves are mostly falling. But its very hard to know what’s going on with state-owned oil firms, such as Saudi Aramco, who hold the bulk of the world’s oil and gas reserves.

  18. Hal

    I agree with haraldb that today’s prices do reflect to a large extent the expectations for the future. One caveat is that I have seen carrying costs quoted as high as $6/bbl/year, so this could still support a considerably higher price structure for the more forward looking futures contracts than we see today. OTOH the cheapest way to store oil is simply to leave it in the ground, so if the market really thought it was going to be far more valuable in a few years then we’d see oil being withheld from the market today, which doesn’t seem to be happening (instead, producers are pumping as hard as they can).
    Another possibility is that today’s high prices don’t reflect any short term shortages or supply/demand crunch. Rather, they are in fact a manifestation of the phenomenon that haraldb cites; expected future shortages are what has caused oil prices to double in the last year. And as the evidence for future shortages becomes stronger, we can expect oil prices to continue to climb steadily in the immediate future, well in advance of any actual peak in production or supply/demand mismatch.

  19. JDH

    That’s fine, Hal. But I still say, if you believe that oil will continue to climb steadily in the immediate future, you should just buy oil futures today. You don’t have to store oil, you don’t have any carrying costs, you just have a pure profit that you’ll make if you’re right. And the point is, the guy on the other end of the deal selling you that contract doesn’t think you are right.

    You’re absolutely right that the peak oil story could perfectly well explain spot prices doubling in 2004. But it cannot explain a downward slope to the price structure beginning in 2006.

  20. Olson

    1. It seems that no commodities trade for disproportionately high values way out in the future.
    2. The highly pessimistic view doesn’t imagine (forecast?) a very stable institutional structure post-peak (i.e. contracts could be dishonored).
    3. US-48 oil production also dramatically increased right up to 1970, and has been downhill since.
    4. I understand that Russia is not exactly pumping at capacity and could be strategically withholding. Also, related to (2) above, the Yukos story, Iraq, and the developing story in Bolivia could be viewed as indicators of the risk in long-term futures.

  21. dfg

    There is one situation that holds out the possibility that the markets believe peak oil is here. If decreasing oil supply is expected to be matched by a decrease in demand. If the markets are fundamentally pessimistic about the future economic prospects of the world economy (I understand the flattening of the bond yield curve may indicate that the markets are pessimistic) then the resulting reduction in oil use could exactly match the loss of production due to depletion for the next few years leaving the futures price flat.

  22. The Oil Drum (heading out)

    Thanks for the plug. One of the interesting things about this debate is that there will come an answer. In other words by this time next year we will have a much better set of data than we do now. A couple of minor points however, In our particular institution I am ethically constrained in the agreement I signed when I was hired as to what I can invest in. (And when I was talking to a stock broker he said the same thing). And the other thing I have noted is that there have been a few “experts” on various chat shows that have told us over the past year the we would already be back down to $25 – $30 oil.

  23. Jason Bradford

    I have been telling people to invest in oil futures for a few years now because of my belief in a near-term peak in oil. The same can be said for natural gas, especially in North America, which has already peaked and is expected to be the fuel of choice for new electric generation and hydrogen production (one of the dumbest uses I can imagine). So thanks for finally laying this out. It’s about time an economist did so.

  24. Brad DeLong's Website

    James Hamilton from UCSD Joins the Party…

    He is incredibly smart and incredibly hard working: we eagerly look forward to lots of refreshments: Econbrowser: June 09, 2005 Oil futures and the future of oil Commodity traders can have as hard a time as any of us trying to predict oil prices. But i…

  25. disinterested party

    The oil-price bubble

    It doesn’t seem like two months ago that I wrote this: In many ways today’s oil market reminds me of the dot-com insanity, what with analysts like Goldman Sachs’ Arjun Murti channeling Henry Blodget, predicting $105-a-barrel “super spikes,” a…

  26. disinterested party

    The oil-price bubble

    It doesn’t seem like two months ago that I wrote this: In many ways today’s oil market reminds me of the dot-com insanity, what with analysts like Goldman Sachs’ Arjun Murti channeling Henry Blodget, predicting $105-a-barrel “super spikes,” a…

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