Streetwise Professor

October 12, 2007

Back to the (Oil) Futures Backwardation

Filed under: Commodities,Derivatives,Energy — The Professor @ 8:16 am

In “Care to Dance the Contango?” I analyzed in some detail the movement of the oil into contango–where prices for future delivery are above nearby “spot” prices. Consistent with the theory of storage, the move to contango coincided with massive increases in the amount of oil in storage.

Now, the market for oil has moved into backwardation–the typical state of the market since the birth of crude futures trading in the early-1980s. And, surprise, surprise, inventories of oil have fallen. The theory of storage strikes again.

This movement in oil inventories and prices was discussed in a recent WSJ article (subscription only). There are glimpses of economic sense in the article, but there is a lot of nonsense too. I doubt that the lay reader could make heads or tails on why inventories have fallen. One problem is that prices and quantities are determined simultaneously, but author Ann Davis makes statements about price structures causing inventory levels. Most importantly, the article Rounds Up the Usual Suspects–speculators–and attributes the movements between contango and backwardation to their whims.

Speculators participate in the market, and big financial firms such as Morgan Stanley have staked out big positions in the physical oil business. But speculators are responding to fundamental economic conditions, not dictating prices to move contrary to levels and structures justified by fundamentals.

As I noted in “Care to Dance,” the move to contango was a rational response to fundamental market conditions. The oil forward curve goes into contango when the current supply is abundant relative to expected future supply (or, put differently, when the current supply/demand balance is less tight than anticipated supply/demand balance.) Given the widespread anticipation in late-2005 of repeated hurricane-caused supply interruptions in the Gulf of Mexico; geopolitical unrest in the Middle East, Nigeria, and Venezuela in 2005-2006; and expectations of robust world growth in the future, as tight as supply conditions were in fall 2005, it was reasonable to believe that supply conditions would become even tighter in the future. Under these conditions, holding higher precautionary inventories was economically efficient; inventories rose accordingly; and the market moved into contango.

In recent months, the most acute fears of future supply disruptions due to hurricanes, political unrest, etc., have dissipated, and the subprime crisis has reduced expectations for future economic growth. Under these conditions, precautionary stocks needn’t be as large. Hence, we’ve seen the drawdown in stocks and the concomitant move of the forward curve into backwardation.

Speculators are an important part of this process. It is their job to assess market conditions and take positions accordingly. They are essentially conveyor belts that transform diffuse information about current and future supply and demand fundamentals into real economic decisions that affect prices and quantities. They are not always right of course, when viewed retrospectively, but that’s because the world is an unpredictable place and the best information today only imperfectly forecasts the future. But speculators are responding to market conditions, and the market is a harsh taskmaster. There are rich rewards to being right, and harsh punishments for being wrong. So, rather than lazily attributing any movement in prices and quantities to the deus ex machina of speculators, it would be far better if journalists and other analysts would think a little more thoroughly about the fundamental economic forces that really drive markets–and speculators.

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