I’ve just finished a new research paper with my former student (and now University of Chicago Professor) Cynthia Wu. In our new paper, we study how increased purchases of crude oil futures contracts by financial investors may have affected the prices on those contracts.
A crude oil futures contract is an agreement between two parties to purchase oil at a future date at a price agreed upon today. For example, on Friday the November contract closed at a price of $88.18, meaning that if both parties were to hold on to the contract until expiry (which for this contract happens to be October 21), the seller would be obligated to deliver 1,000 barrels of crude oil to the buyer some time in November at a location in Cushing, Oklahoma at a price of $88.18 per barrel. Most people who buy or sell these contracts don’t actually hold them to expiry, but sell their positions to somebody else between now and then. The easiest way to think about this is if on next Wednesday, Friday’s buyer ends up selling the November oil contract back to the original seller, after which they both walk away clean. If the price of the contract goes up between Friday and Wednesday, the original buyer will have made a profit and the original seller will have made a loss.
If both parties don’t care about the risk, the price they agree to today would be the same as the price they’d expect to pay if they were just to wait until October 21 before making any agreement. However, providing a way of coping with risk that one of them would prefer to avoid is one of the principal reasons these contracts exist. For example, a producer of crude oil might be worried about its ability to maintain cash flow if the price of oil were to fall. They might then want to sell a futures contract. If the price of the oil they produce subsequently falls, the futures price will likely fall with it, and they will receive a cash gain from their futures position to offset the lower revenues from sales of oil. From their point of view, selling a crude oil futures contract is like buying an insurance policy. As with any insurance policy, if you’re risk averse you’d be willing to pay a premium for the policy that is greater than the expected value of the cash flow you receive from the policy.
But who would take the other side of the contract? The would-be buyer also faces various risks, and taking the long position in a crude oil futures contract may expose the buyer to risks that are hard for them to diversify away. If lots of oil producers are anxious to sell futures contracts for purposes of hedging, what we might see is that the price today of a November futures contract gets depressed a little bit below the rational expectation of what the price will actually be on expiry. That difference means that the buyer of the contract expects to receive some gain, on average, as compensation for the risk. The seller, on the other hand, is willing to pay that premium in order to achieve the desired hedging.
This was the basis for Keynes’ (1930) theory of backwardation, according to which hedging pressure from commodity producers might typically lead to a current futures price that is below the expected expiry price. Keynes’ theory has received empirical support from studies by
Carter, Rausser, and Schmitz (1983), Chang (1985), Bessembinder (1992), De Roon,
Nijman, and Veld (2000), and Acharya, Lochstoer, and Ramadorai (2010), among others.
The graph below plots the total open interest on NYMEX light sweet crude oil contracts since 1983. There was tremendous growth in use of these contracts after 2004. Part of this growth resulted from increased use of these contracts as a financial investment. One popular strategy is to buy a November contract today, and plan on selling that November contract in October in order to turn around and buy a December contract. Such a strategy would leave you always with a long position in oil, from which you would benefit when the futures price rises and lose when the futures price falls. The strategy might provide some portfolio diversification. For example, when oil prices rise, other assets in your portfolio such as stocks might do poorly. Price pressure from such purchases of futures contracts as an investment vehicle could have a similar effect as traditional hedging from producers but in the opposite direction. Purchases of futures contracts by financial investors basically forces arbitrageurs to take the short position on contracts, whose compensation might then come in the form of a futures price that is above the expected expiry price.
In a new research paper with Cynthia Wu, we develop a simple model of how selling pressure from commercial hedgers or buying pressure from financial investors would interact with risk-averse arbitrageurs to determine the relations between futures prices of different maturities. One of our innovations is a full characterization of the dynamics and the role that risk premia seem to play in influencing those relations. We find that there have been very dramatic changes in these relationships over time, which we allow for by estimating different parameters for the model over the 1990-2004 and 2005-2011 subsamples.
The graph below plots our estimate of the risk premium associated with a contract that would expire 8 weeks from the indicated date, where the risk premium represents how much higher the price of the contract would have been at that date if there had been no hedging pressure from commercial producers or financial investors. For the period before 2005, the premium is uniformly positive. We calculate that the price would typically have been about 2-1/2% higher over this period in the absence of any risk aversion. This is consistent with Keynes’ theory, which would interpret that risk premium as the compensation to arbitrageurs for providing insurance to commercial producers.
The above graph also reveals how differently the risk premium seems to have behaved in more recent data. The average compensation to the long position is largely gone and even reversed in recent years, consistent with the view that arbitrageurs are now profiting not by buying from commercial hedgers but instead from selling to financial investors. However, the volatility of the risk premium is also significantly greater than it used to be.
Our paper is focused entirely on the relation between the prices of futures contracts of different maturities, and we do not attempt to make any statements about the more interesting question of what effects increased financial participation in crude oil futures markets may have had on the spot price of oil, a topic on which I offered some thoughts a few weeks ago. But our new findings are consistent with the claim that use of futures contracts as a vehicle for financial investment has influenced the dynamic behavior of futures prices.