Streetwise Professor

October 13, 2007

More on Backwardation

Filed under: Commodities,Derivatives,Energy — The Professor @ 8:06 am

James Hamilton is a great econometrician, and has written importan tpapers on the relation between oil and the economy. He blogs periodically on the oil market. Yesterday he posted this piece on backwardation. Like my piece, he discusses Ann Davis’s WSJ piece. Overall, I think Hamilton’s take is reasonable, although he does engage in one of my pet peeves, by attributing the increase in storage to the contango in the market. As I noted yesterday, prices and inventories are both endogenous, and determined simultaneously. As the Welfare Theorems show, in a competitive market prices adjust to induce agents to take the first best actions. Therefore, saying that “storage increased because the market moved into contango” is an incomplete analysis. One must push the analysis back one step to understand what economic forces made it optimal to increase the amount of oil in inventory. When talking about forward curves, the key forces are market tightness today relative to expected future tightness.

Hamilton’s post reproduces the graph of oil forward curves (from last week and a year prior) that ran in the WSJ. The interesting thing about the graph is that when the market was in contango a year ago, distant dated forward prices were substantially lower than they are today when the market is backwardated. This illustrates an important point; it is not the level of market tightness per se that drives backwardation or contango. It is tightness today relative to what is expected in the future.

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