Contango, speculation, and the price of oil

Lynne Kiesling (Knowledge Problem),
John Whitehead
(Environmental Economics)
,
Stephen Ayer
(Disinterested Party)
, and whoever that is blogging over at Oil Wars were among those commenting on this article ($$ required) at the Wall Street Journal.

Bhushan Bahree and Ann Davis wrote in last Tuesday’s WSJ ($$):

Crude oil closed above $70 a barrel for the first time, highlighting a phenomenon reshaping the petroleum world: investment flows into oil futures are supplanting nitty-gritty supply-and-demand data as prime drivers of prices

In contrast to past bull markets in crude, this year’s run-up has occurred even though oil inventories in the U.S., the world’s largest market, have swelled to their highest levels in nearly eight years….

The answer to the puzzle posed by rising prices and inventories, industry analysts say, lies not only in supply constraints such as the war in Iraq and civil unrest in Nigeria and the broad upswing in demand caused by the industrialization of China and India. Increasingly, they say, prices also are being guided by a continuing rush of investor funds into oil markets. Institutional money managers are holding between $100 billion and $120 billion in commodities investments, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PLC….

Since early 2005, the crude-oil market is in what traders call contango, meaning futures contracts for a given product are priced higher than that same good for near-term delivery. The price of oil to be delivered four months from now is about $3 more than oil to be delivered next month.

Flooded oil storage near Port Arthur, Texas
oil_storage2.jpg

In short, it pays for refiners and other oil-market players to buy and hold oil now to sell it down the road. Making that trading opportunity possible, says Colorado-based oil analyst Philip K. Verleger, is the huge volume of new buyers on the other side: investors who he estimates have put more than $60 billion into U.S. crude-oil futures since 2004.

Indeed, San Antonio-based Valero has been operating with its crude tanks full since the start of the year. When the market is in contango, “you tend to operate at the top of your tanks,” says Bob Beadle, Valero’s senior vice president in charge of crude oil, supply and trading. Mr. Beadle estimates that in the U.S., the difference between the industry operating at full tanks and at minimum operating levels amounts to as much as 75 million barrels of oil, or about three days of supply.

I do not share the view that speculation should be thought of as a separate force from supply and demand contributing to the price of oil. An investment fund that today buys a September 2006 futures contract for $75 ($3 above the current spot price of $72) will only make a profit if the spot price of oil in September turns out to be above $75 a barrel. If such speculators prove to be correct and the spot price does rise from its current $72 to, say, $80 a barrel by September, that price hike would be a further factor depressing September demand and potentially increasing September supply. Why would the September spot price be even higher than the current spot price, if users of oil in September will be buying less oil than they are now? According to the speculation theory, we’d have to see even more investment dollars flowing into the market in September than we are currently, causing an even bigger addition to stockpiles (that is, the rate at which oil is added to storage must itself go up at an ever-increasing rate) in order to compensate for the lost demand that $80 oil would choke off as well as to justify an even higher price than at present. And that additional money, in turn, would supposedly be going into February 2007 contracts for $83 oil, in hopes that the February 2007 spot price would be even higher, say $85. All this only makes sense if one believes that investment funds will continue to pour ever-increasing sums into oil futures and an ever-increasing volume of oil gets added to inventory each month. Since the total investment funds and physical facilities for storage are inherently finite, someone in this chain is going to find that they have irrationally thrown their money away. I would argue that this someone is in fact the joker at square 1 who thought you could make money with a September 2006 futures contract betting against the fundamentals.

To me, a much more natural way to try to interpret this phenomenon is that the investment funds are betting not on a bigger fool to bail them out in September, but rather are trying to evaluate the September fundamentals for supply and demand. First, let’s look at the upside. There is currently very little spare capacity in global oil production, meaning that a supply disruption of just a few million barrels a day could easily result in a pretty impressive spike up in the spot price of oil in September. Where might such a supply disruption come from? Oh, maybe Nigeria, or Iran, or Iraq, or Saudi Arabia, or Venezuela, or Russia, to name a few. Even if the probability of such an event is low, the large payoff if it occurs could give an attractive expected rate of return– play such a gamble over a long enough time period, and you could make out quite well, even if everything remains calm over this particular coming six months.

And what about the downside? Certainly a global economic slowdown could bring oil demand and the September spot price down considerably. But my reading is that the economic news of the last two months has led investors to place a lower probability on a global downturn than they would have assessed at the start of this year. Another development that would lower oil prices is if we finally started to see big changes in how oil gets used (for example, a significant change in the fuel efficiency of the outstanding stock of vehicles). But again, the most recent evidence is that this doesn’t seem to be happening yet. And finally, big supply increases from new oil fields were expected by some to have been making a contribution by now, and again the news is that, so far at least, they haven’t.

So, it seems to me that speculators, weighing these ups against the downs, might quite rationally have decided that market supply-demand fundamentals justify a higher futures price than seemed appropriate a few months back.

I would further add that, if these speculators turn out to be right and earn themselves a tidy profit, they will have done us all a favor. By bidding up the price of oil today and filling the storage facilities to the brim, they will have caused consumers to conserve today in order to have more oil available in the event that we do run into a big shortfall in production before September. On the other hand, if the speculators turn out to be wrong, they bought high and sold low. That would be destabilizing, forcing us all through some current pain, which, if we somehow could predict the future with certainty, will turn out to have been unnecessary. Our only consolation would be that the speculators will undoubtedly feel our pain, and then some, as their multibillion dollar bets flew into the wastebasket.

So, the only reason I see to be concerned about the contribution of speculation is if you think that the speculators are in danger of making huge losses. But if that’s your concern, I have a simple cure– just put yourself on the selling side of some of those futures contracts– let their pain be your personal gain.

Not sure you want to take the other side of that bet? Then maybe you’re not so sure that the speculators are wrong in their assessment of the possibilities for September fundamentals.


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36 thoughts on “Contango, speculation, and the price of oil

  1. EconLog

    Oil Hoarding

    James Hamilton summarizes and comments on a blog discussion of the fact that oil futures prices are high relative to…

  2. T.R. Elliott

    I agree. The markets are working as they should.
    Now if we can only get the demagogues on both the right and left to read your post and take it to heart. The finger-pointing preachers with their chorus of blamers is deafening.

  3. TruePress

    “Contango, speculation, and the price of oil”

    Econbrowser on the occurence of high oil prices contemporaneously with high levels of oil inventories.

  4. mickey

    What about the nearing of peakoil. If peakoil is here now the price should go up and down like it does now

  5. amsaar

    we can speculate the price of oil, but canyou tell me how much adesabled soder cost American tax payer to keep?
    we have 10,000s of the now, the unforetunate road still long, there is no lights in the end of tunnel, can any of expert come with a figure please?
    do we know how much the desabled will cost us , any clue?
    just look at these picture?
    These picture Bush avoid american to see
    achievement in Iraq
    http://www.voltairenet.org/article137035.html

  6. ow

    “All this only makes sense if one believes that investment funds will continue to pour ever-increasing sums into oil futures and an ever-increasing volume of oil gets added to inventory each month. Since the total investment funds and physical facilities for storage are inherently finite, someone in this chain is going to find that they have irrationally thrown their money away.”
    This is certainly very true – the point being that even if current prices are somewhat speculative any bubble in a commodity such as oil is likely to be short lived. Up until I read the WSJ article I had never been a believer in the idea of speculation being a significant factor in current oil prices – after all how much oil could people have sitting around in storage doing nothing? But the chart they had showing a large increase in the amount of money flowing into commodity investment funds made me reconsider. In any event, we should find out the answer in the not to distant future.
    On a tangential topic I’m wondering if you’ve ever analyzed this from an oil exporting country’s point of view. In Venezuela there has been a heated and ongoing debate as to what the best policy would be with respect to oil production. Some (including the current government) have argued that as oil is a commodity with an inelastic demand curve it makes sense to participate in OPEC, restrict production, and hopefully boost prices enough to increase overall revenues. Opposed to this is the idea that OPEC doesn’t really have the ability to significantly effect oil prices over the long run and that the country should therefore just produce as much oil as it can as prices will fluctuate more or less independently of what Venezuela produces.
    I have always tended to side with the former view and the substantial increase in oil prices since 1999 when the Chavez government helped revitalize OPEC have tended to confirm the validity of that viewpoint for me.
    But as this blog is written by economists I was wondering if they had opinion on the subject and what they would advise a poor country heavily dependent on oil exports to do.

  7. T.R. Elliott

    mickey: JDH has the video for a talk he gave in which he describes how some of the signs we are seeing in the markets is indicative of peak oil.
    With oil production at todays levels (somewhere around 80 mbpd), a percent increase in demand or a percent decrease in supply (due to depletion) implies a lot of capital to produce the rigs and drills and people who will meet that difference.
    If the easiest oil is largely gone (or trapped by politics in Iraq and Nigeria), we should expect to see exactly what we are seeing: a new price level for oil.

  8. Nick

    OW,
    The answer is easy: OPEC (and it’s members) should keep prices at the highest level that won’t push it’s customers to alternatives. That level is probably around $40.
    At current prices oil consuming nations, especially the US, will move as quickly as they can to alternatives, especially coal-to-liquids from the US’s enormous coal reserves, but also plug-in hybrid cars. Once they have developed the alternatives to the point where prices start dropping from efficiencies of scale, the alternatives will be unstoppable, and drop in price to the point where OPEC countries will no longer be able to make much money.
    This may take 10 or even 15 years (depending in part on how quickly the US wakes up to the problem), and may be profitable for OPEC and painful for consuming countries in the meantime, but it will sacrifice the long-term health of OPEC.
    Yamani of Saudia Arabia knew this very well, and took great care to keep prices well below $40. OPEC has either lost control of prices, or has lost it’s good judgement in a fit of short-term profit-taking. Probably the former, but hard to know which for sure.

  9. T.R. Elliott

    Nick: I’m not at all convinced that $40 is the price for alternatives as you describe it. Where did you get that number from? All analysis I’ve seen of such numbers tend to be half-heartedly thrown together, not taking into account EROEI, not taking into account significant capital expenditures for alternatives, etc. My arguably non-quantified intuition tells me that at $100 oil will, with some pain and adjustment by consumers, still produce a long line of customers with tankers at OPEC ports.

  10. ow

    When Venezuela first assumed leadership of OPEC in 1999 they actually introduced the idea of a price band – they would try to keep prices $22 and $28 per barrel. Seems very low now but at the time those were significant increases.
    Clearly that price band has long since been rendered obsolete. But a new price band in the $50 or $60 range would make sense from a producers point of view. I would agree that the current price might be pushing the envelope of what will start getting people to look into alternatives.
    T.R. is correct that current prices are still not at peak by historical standards, espcially when viewed as how many minutes a person has to work to purchase a gallon of gasoline. The easiest way for people to conserve is for them to drive more slowly and so far I haven’t noticed that.

  11. Hal

    The “contango” relationship of oil only applies to the next six months or so. See this chart of today’s closing oil futures prices for different maturities:
    http://alumni.caltech.edu/~hal/oil20060426.png
    Beyond the end of this year, oil goes into a state of “backwardation”, with prices getting lower every year out to the 2012 horizon. I’m not sure what this tells us but this is a very common shape for the oil futures price curve.

  12. Aaron Krowne

    An excellent post.

    The sudden interest in “speculators” is just a distractionary attempt to lay the blame on an old boogeyman for what are actually results of seriously troubling fundamentals in energy.

    Same deal with “windfall profits”. No one cried for the oil companies when they went through a decade of painful contraction in the 90s. If anything, this is fair, not a “problem” in itself.

    In the short to medium term, there is nothing anyone can do about the energy squeeze—not energy companies, not the government, not the international community. Wars won’t help, investing will take too long to bring innovations to market, and expanded capacity will take too long to come online. In the face of this, the power of denial is truly a thing to behold.

  13. Jon

    There’s another way to look at this as well – spreads – many of the commodity funds are “long-only” and their buying is concentrated in the first or second delivery option. As the contracts near expiration, they need to roll into the next contract in order to maintain their long positions.
    The hedgers and short-term speculators know this and drive the spreads out in order to make money – the “long-only” funds have to pay dearly to maintain their position – a long rolling M/N right now would lose about $1.50 while the short hedger would gladly take.
    Furthermore, this contango situation pays the producer to keep the commodity off the market – producers are essentially paid that $1.50 to wait a month before selling. IOW, supply and demand factors further drive the contango nature of this spread – the same thing is happening with wheat, beans and corn for example because there is ample supply of product to “justify” the market “paying” the producer to keep it out of the pipeline.
    Do note that contango is only running until the Jan 2007 contract when backwardation takes place – which isn’t terribly surprising given that A) there is far less “speculative” interest in deferred contracts and B) there is far less spread pressure. The majority of traders out there are hedgers….
    For the Peak Oilers out there….the market here is very clear – buy deferred contracts and get a bigger “bang” for your buck.

  14. Hal

    OW, economically speaking the advice for oil exporting countries is very clear. Look at the oil futures market to get an idea of the expected trends for future oil prices over the next few years.
    If the trend is for flat or declining prices, produce as much as you can today. The money you will receive for your oil in the future, once discounted to the present value, is worth less than what you can get for your oil today.
    If the markets predict rising oil prices in the future, then it is time for you to hold back on production levels and in effect move oil sales from the present into the future, when they will be worth more.
    Right now markets are predicting that oil prices will be about 5% more at the end of the year than today. 5% over 7-8 months is pretty significant so it would probably make sense to hold back on production today.

  15. Jon

    Aaron – do you know the difference between a “squeeze” and a “bull market”?
    You have a long in a bull market – in a squeeze, you have no position and everyone else is making money while you’re sittin’ on the sidelines….
    (That’s a joke in case the super-serious out there can’t figure it out….)

  16. bonzo lives

    Could the contango leading into backwardation in January 2007 – the bulge in price over the next few months – could that not simply be a reflection of what is understood to be the current price of regime change in Iran over the same time period (times the odds of that regime change occurring)?
    If so I believe the price of oil is still heavily discounted…and no doubt we will see after April 28…

  17. sully

    If the speculative element is well financed and organized on the buy side with the objective of creating a short term impulse, the market would act in a similiar way. Since futures are priced on the margin, a concentrated organized attack would have the effect of a short term spike in the market. It happens every day in individual stocks.
    A buying impulse, delivered at the slow trading time of day, intially blows out the stop loss levels on the shorts, creating momentum as the short covering buying adds to the trajectory.
    Momentum hedge fund computers pick up the second derivative change and issue buy orders, taking out consecutive levels of stop loss. Strikes in the longer term contracts as well as the natural tendency for all maturities to rise in tandem spreads the impulse. Physical buyers panic and join the buying trying to lock in next week before the price increases more.
    Short sellers attempt a few forays but are met with ferocious buying, become demoralized, adding to the snap back through short covering, and exit the market, leaving it open to the leveraged, big money team.
    Technical driven funds, see resistance crushed and cover short positions and go long at any point in the curve that appears “undervalued”.
    When the momentum begins to fade, the pioneers reverse field, selling as ferociously as they bought. The impulse subsides.
    The impulse never intends to take delivery, so contango doesn’t really mean that much. All that matters is that the target contract is vulnerable and will go up in value.
    The monthly average price reflects a blip that soon becomes lost in the avalanche of data. Economists assume that the financial markets aren’t rigged and fit the data to hypothetical models of supply and demand.

  18. Houston's Clear Thinkers

    Confounding contango

    This post from last week noted the seeming contradiction between rising oil prices at a time of rising inventories and the current longstanding “contango” in the oil trading market — i.e., futures contracts for a given product are priced substantially…

  19. kharris

    I agree with the overall analysis, but I think I have a quibble about the insistence that an investor who holds oil off the market has to sell it at the spot rate in the future. That may be true on an aggregate basis, but can’t individual oil holders commit to sell oil at the current futures price, locking in today’s spread? They should be able to calculate whether their own cost of carry and storage, and thus be able to know whether holding oil for future delivery at today’s price is a money making prospect.

  20. JDH

    kharris, You’re right that the typical speculator who buys a futures contract is not planning on ever physically taking delivery of the oil, but instead simply intends to sell the contract to somebody else when it gets closer to expiration. At expiration, arbitrage forces the futures price to the then-prevailing spot price.
    By bidding up the futures price, the speculator generates a risk-free opportunity for anyone who physically holds the oil to keep a little more in inventory and sell forward, as explained in both the WSJ article and my own earlier post on the topic.
    There are a number of separate actors in this chain– the original speculator who bought the futures contract, the person who adds physical oil to inventory , and the person who later buys the contract back from the original speculator are all different, and indeed the actual story is usually much more complicated than this with many other people participating in buying and selling futures contracts as well as spot oil. But, the prices are all tied together by arbitrage. I believe that the correct way to get to the bottom line is to think about one person doing all the calculations, which is how I described it in my original post.

  21. juan

    Sully pegs it, and I would add that this particular speculation has been of some duration; that there is no necessary direct link between the price of paper barrels (fictitous oil) and the physical, i.e. inventories don’t have to build in concert, that less than 5% of Nymex CL contracts take delivery and increasingly the same on the ICE.
    After the dotcom episode, it’s hard for me to believe that people still fail to recognize a bubble as price disconnects from fundamentals.
    A closer examination of the data over the last years might help since, among other things, it stands out that the big China demand story was inflated, especially in 2005. Ever notice that it is generally provided as a percent increase while the absolute quantity tends to be ignored. Ever notice that many of the potential disruptions have been both potential and real for much longer than the price bubble. Ever notice that oil price volatility rose substantially post 1983, i.e. after Nymex opened the CL contract.
    It may be handy to think of ‘one person doing all the calculations’ but, as you note, that’s not what takes place.

  22. Mark E Hoffer

    Anyone give any consideration to the idea that the higher Oil price has something to do with the deluge of Fiat that has been created worldwide?
    Seriously, if a good, X, trades @ 1/U$D and the “value” of the U$D drops, how does the original 1, adjust?
    Personally, the rain of “dollars”, our “unit of account”, is going to cause a great warping of the frame of our historical price information.
    The old saw, ” “Money” created over and above the amount of goods & services available leads to….”
    hasn’t fully rusted into uselessness, has it ??

  23. Voltron

    I got a dumb question. What is the best way for an average person to bet against the speculation. Is there an easy way to mimic the investment of writing a future’s contract?

  24. dhatz

    “But, the prices are all tied together by arbitrage.”
    Do you have any information about actual arbitrage between the spot (“wet barrels”) and futures (“paper barrels”) markets?
    Considering that e.g. Brent is ~1% of global (physical) oil production and yet 60% of worldwide oil trade (~80 million barrels per day) is priced off Brent.
    It seems to me that those holding those few precious Brent barrels, can set oil prices almost at will.
    The near WTI NYMEX contract trades 150Mbpd. The NYMEX oil open interest is >1 BILLION barrels. The 2 nearby Brent futures contracts trade over 100 million “paper barrels” per day.

  25. matt

    Citigroup published a report titled ‘Beyond fundamentals the funds phenomenon’ in Jan 06. If you look at the increasing volume of speculative investments in the commodities markets over the last few years – yes, there is just an increasing amount of money pushing up prices month on month.
    Not being an investment banker with wads of other people’s cash to play with, I can’t put my money where my mouth is – pointing out that there is a bubble is not the same as predicting exactly when it will crash.

  26. Spencer Hall

    Some people prefer the Devil Theory of inflation: “It’s all OPEC’s fault”. This approach ignores the fact that the evidence of inflation is represented by the actual prices in the marketplace. The administered prices of OPEC would not be the actual market prices were they not “validated” by MVt…adjusted member commercial bank legal reserves have declined for 7 months in a row.

  27. Ben Claassen

    Speculation, Optionality, & Risk Models
    Trading around assets for natural gas futures, gas storage, and electricity, lived and grew strong under the war cry of “optionality”. The same real or imagined rewards for being smart like Enron, apply to crude oil futures.
    In an operating world, owning a refinery, making gasoline and other fuels, and having tank storage as a sunk cost, who would not fill storage tanks to a level that offsets the risk of a supply disruption. A supply gap that could leave some refineries short of crude and see gasoline prices that exceed all past prices? Create and run the strategic decision model and you will fill your tanks, too. Next topic– ways to move to zero oil imports by 2010?

  28. Ryan

    “If such speculators prove to be correct and the spot price does rise from its current $72 to, say, $80 a barrel by September, that price hike would be a further factor $$”depressing September demand and potentially increasing September supply”$$”
    Well, i’am a student in finance and I can’t understand why the price hike would depress september demand and increase september supply.
    If price is increasing, more oil will be demanded for storage and less available for supply.(Something tell me that i’am wrong!)
    Please, can someone help me!!!

  29. JDH

    Ryan, presumably you’re agreeing that a higher September price means that September demand, apart from that arising from folks wanting to store the oil, has gone down. Furthermore, a higher September price is an additional incentive for production from marginal wells. So, the only way that total September demand goes up, as you claim it would, would be if the increase in storage in September is even bigger than the increase in storage in April. And, if you believe that it would be, I won’t let you end your analysis there, because you’ll need an even bigger increase in storage six months after September, an even bigger increase than that six months later, and so on.
    If the “and so on” part of your story is infeasible (and I submit that it is), the whole chain unravels.

  30. Ryan

    JDH, tell me how the price hike to $80 cause the demand for september to fall? I have still not understand this part
    I would also like to know whether when a future contract expire, does the delivery of oil really occurs as speculators don’t need the oil but the future contracts to buy and sell…

  31. JDH

    Ryan, a higher price of gasoline means some people cannot afford as much and others choose to use less. For evidence that gasoline demand declines when the price goes up, see this.

    If you buy oil, either you’re going to use it to make something like gasoline or you’re going to store it. My observation is that the demand for purposes other than storage goes down when the price goes up.

    As for settlement of futures contracts, some are financially settled, fulfilled by delivering a cash sum based on the spot price of oil that is physically sold elsewhere on a separate market. Other futures contracts, such as the NYMEX light, sweet crude contract, are settled by physical delivery. However, a speculator who buys a physically settled contract does not hold it all the way to maturity, but instead sells it off prior to the delivery date to take profits in cash.

  32. Ryan

    JHD, I have try to understand how the future market works by taking a practical example. Please, tell me whether it is correct or not?
    ILLUSTRATION
    1.Spot price of oil in January 2006 is $60.
    2.Supply of crude oil is expected to be low in future and as a result, investors expect future spot price in July 2006 to be $70.
    3.For speculators to purchase the July 2006 future contracts, the future price has to be set between $60-$70, for them to be able to do arbitrage and earn profit. Let us say the future price is $65.
    Right from the start, we noticed that the market is in Contango.
    Effect in Spot Market
    Speculators could profit from this situation by buying spot oil at $60 with borrowed money and store it for future delivery (as a higher price of $70 is expected).
    As a result, users of oil will also demand more oil for storage, where the overall demand of oil in the spot market will increase, the supply will depress, causing the spot price to rise.
    Effect in Future Market
    Moreover, speculators will buy July 2006 contract in January at $65 and sell it when the spot price goes beyond $65 (caused by increase in demand in spot market), thereby making the demand for future contract decrease. The result will be a progressive fall in the price of future contract until the spot price equals the future price at the expiration of the July 2006 future contract.
    I think that something is wrong about the purchase and sales of the July 2006 future contract!!!

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