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195 comments on DrumBeat: July 17, 2007
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195 comments on DrumBeat: July 17, 2007
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Oil futures market in backwardation
While listening to CNBC this morning, the NYMEX floor reporter was commenting on the recent run up in the price of crude oil. She stated that the oil market was in “backwardation”, and this meant that this was a ”demand driven market”.
This shocked me because only about a month ago I did an Excel chart of the current and all future contracts and the market was purely a contagion market all the way out. Prices of the further out markets ran up gradually, hitting a peak about a couple of years out then gradually declining, but never down to the current price of the closest contract.
So I ran a chart of the current market and sure enough, it is now completely in backwardation. Only the September contract is higher than the August contract, which expires this week. All other contracts are lower with the lowest contract, December 2014, at $72.25.
I find this very significant. The current price is up around the world because a shortage of supply is driving the market. The current price is what buyers are having to pay to get oil. The futures price is what traders expect the price to be at in the future. They could be very, very wrong in that assessment, and I believe they are. But the point is, the current price represents actual demand and because it is worldwide, not just local, that cannot be denied.
One more important point. Last year, and the year before for that matter, the price of oil had about a $20 terror premium built in, (more or less). But any terror premium is reflected far more in the futures contracts, six months to a year out, than in the spot price or the price of the near term contract. That is, traders expect something might happen in the future to push up the price of oil. Now traders are far more relaxed about the future, expecting prices to drop. Therefore I conclude that the current price of oil is far more reflective of the current availability of supply than it has been in recent years.
Edit: One point I forgot to add. OPEC meets in September and it is likely traders expect them to increase production then. And when the don't??? Look out, the preverbal excrement will then hit the fan.
Ron Patterson
The traders may be anticipating demand destruction due to the the upheaval in the credit markets.
If that were so then that same expectation would be reflected in the equities market. It quite obviously is not because the market is currently at an all time high.
The stock market reflects what traders expect in the future. They obviously expect all smiles and sunshine for the economy in spite of what is happening in the credit or housing market. They expect oil prices to fall and they expect the economy to continue to boom.
Ron Patterson
Expectations for stocks and bonds don't have to coincide. Investors may be pushing stocks to a new high as they try to get out of the debt markets - out of the frying pan, into the fire (this autumn IMO). They may still be anticipating that credit tightening could reduce the speculative gloss on oil. IMO the oil price will tank, along with most other asset classes across the board, when the markets finally fall.
Gad, how could you possibly be more wrong? Expectations of the stock market and bonds always coincide. People move into the credit market when they expect equities to fall and vice versa. That is the way it always has been and until the market dissolves into chaos, that is the way it always will be.
That is, if investors expect a greater return from bonds than from stocks, the money will move their investments into debt instruments, both of the government and industrial variety. This always happens when people expect the stock market to fall. But if they expect the equities market to keep on booming, they will move from bonds to stocks, causing interest rates to rise as debt instruments must compete with equities for the investment dollar.
That is exactly what is happening right now. Interest rates are rising as they try to compete with the stock market. You might note that existing debt instruments are falling in price. This is because the price of an existing debt instrument must reflect the current interest rate regardless of the interest rate the instrument was issued at. That is if a $1000 bond pays 4%, then that bond must drop in price until that 4% is really 5% if 5% is the current going interest rate. Of course other things must also be considered like the amount of time until redemption date, at which time the bond will be worth exactly $1000, no more, no less. Your local broker will give you the formula for this and I am sure it can be found on line.
All this is covered in Economics 101.
Ron Patterson
Why is the word "investor" used when it's very clear the proper word is "speculator"?
Karlof1, traders in commodities as well as day traders and short term traders in stocks and bonds are usually referred to as speculators. However, by a wide margin, most equities as well as bonds, the buyers and sellers are usually investors. If you have a mutual fund then you are an investor. If you hold a stock or bond for over six months then you are referred to as an investor.
Clearly it is a matter of semantics but by a very large margin, most equities are held by investors and institutions owned by investors. Of course it probably would be better to say "investors and speculators" but if one chooses to use only one word, concerning equities, then investors is the better word.
Ron Patterson
institutions may be long term investors, but shorter term price trends have increasingly been set by hedge funds and (per Bill Cara) HB&B- humongous banks and brokers, i.e., the goldman sachs of the "investment" world. stock margin is at an all time high on the NYSE, yen carry trade is enormous, derivatives growth is exponential, etc, etc, this is the engine of speculation. currently there are so many exponential blowoff stock charts it boggles the mind! the rational mind that inhabits TOD would probably agree that financial markets are and have been in a speculative frenzy. further, if inflation is running around 5% which even the Economist asserted, then longer term u.s. treasuries hold no value currently, particularly given the public statements of weimar ben.
jbunt
karlof - I guess that taking money from under the mattress is speculating!
karlof, i "get" your post. given the current stock market bubble, it would appear that these "investors" are mostly of the greater fool variety.
Ron-
Although I thoroughly enjoy reading your contributions to the threads, I do not believe that your bond vs stock assessment is entirely correct.
There are times when stocks and bonds rally together, as in a time of 'soft landing scenario' expectations (Jun '06- Nov '06). There are times when bonds sell off and stocks rally ('99, '87- through Sept, '07). Here are two graphs, sorry i don't have better examples:
http://charts3.barchart.com/chart.asp?vol=Y&jav=adv&grid=Y&org=stk&sym=T...
http://charts3.barchart.com/chart.asp?vol=Y&jav=adv&grid=Y&org=stk&sym=S...
I also believe that the future of bonds is venturing more into uncharted water as it is in the best interests of our largest trading partners (China, Japan, etc) to recycle dollars back into the 'system' to enable their trade surpluses to continue. I believe that to be the lynchpin in the fragile balance as opposed to the theoretical 'investor' who switches between stocks and bonds.
Also, the market is ruled by funds who largely do not switch between stocks and bonds until the 'investor' redeems, and my experience has been that investors switch to bonds After stocks decline/begin declining.
dVincent, what you say is often true but it is the exception rather than the rule. That is, the market will often move up despite rising interest rates. When this happens there is usually something else, something very bullish moving stocks.
Traders watch interest rates like rabbits watching a hawk. Witness the market everytime the Fed raises or lowers interest rates. When the announcement is made, sudden spikes usually mark his decision.
The stock market just loves low interest rates. This means credit is very easy to get meaning people will be buying houses, cars and all kinds of stuff. But if money gets tight, the housing market drops off, profits drop off and the market will plunge.
But of course all these things take time. In the short run, anything might happen. But in the long run, stocks and interest rates move in opposite directions.
Again, the market can move up in the face of rising interest rates but it does this despite the rising rates and not because of them. And if interest rates continue to rise this will eventually have a devestating effect on the market.
Ron Patteson
jbunt
Well, for every 100 people there are 100 theories. Mine is: If there is no cost for money, i.e., a zero interest rate, you will eventually get deflation. This is because it costs a business zero to borrow and expand. So, overcapacity of all material things occurs. See, e.g., Japan for the last 15 years.
Ron-
I agree, and am afraid rates will continue to rise despite all MSM market gurus that expect rates to fall. We are in the early innings of a structural shift away from high investment flows into financial assets and little into hard assets (rig construction, mine expansion, etc.) The cycle historically continues for over a decade and is accompanied with higher interest rates. This time it is likely to be the end game.
Regarding your comment on the next OPEC meeting (Sept) ... the call has gone out for more crude (IEA) and the backwardation of the oil curve expecting more crude from OPEC, what a meeting that will be!
I was about to post a question to the board and this seems like a reasonable place to put it. I'd like to get peoples opinions on the apparent disconnect between oil prices and the stock market. The DOW just hit 14k, and at the same time oil is up .70 this morning to almost $75. It seems to me that cost has to be absorbed somewhere, either with the consumer or the companies bottom line. So why is the DOW hitting new records with oil so high? Thanks in advance.
Shawnott: Both the Dow and the price of oil will rise in resonse to increased liquidity (M3) and a fall in the value of the US dollar. If the US dollar had kept its strength against the Cdn dollar reached in 2002, oil would be priced at $47. Needless to say, the Dow hasn't set any records when priced in Cdn dollars (or many other currencies).
This yet another piece of the puzzle (big picture) why I think that there will be an large jump/switch in oil pricing sometime soon(=next couple years outside).
Followed by many other ugly things...petro-currency switching, military muscle flexing or worse, recession(s).
The M3/monetary inflation can only do so much before other countries begin to bail. Like Russia and Iran, others will have to follow eventually.
And so the new Rome falls. (Nostradamus anyone)
I think people seem to be forgetting that almost every developing and industrialized country in the world is inflating their money supply. Its not just the US!
Sure enough. And they will all likely pop too.
But the US is a world leader...not to let us all down, they will likely POP first!
:-P
Does this illustrate your point BrianT?
It's kind of hard to see but the blue line is the Canadian Dollar in relation to the US dollar and the red line is the Dow. The Dow returned 2.36% in dividends during this time and a daily interest Canadian bank account did about 3%. So I guess for foreign investors it would have been good to sock your money away in a sleep easy ING account.
Piggly: Nice chart. Interesting that the Dow is exactly where it was 5 years ago (in Cdn dollars).
Brian, I agree.
Ever since Nixon did the "Bretton Woods" thing back in 1974 and got us off the gold standard, we have been able to print however much currency it takes to make everybody's "earnings" numbers look good and keep everyone happy.
What miffs me off quite a bit is that the government considers any numerical increase of my retirement savings to be "income", while failing to recognize the dilution of value of my held dollar due to dilution of its value as a loss.
Here's a quickie chart from Seeking Alpha ...
I guess many may be surprised to find even the Mighty US Dollar is also simple fiat currency, printed at will, to cover obligations.
Unlike oil, there is an infinite supply of dollars. We can print as many as we can spend.
Shawnott, I just heard this explanation of this apparent contradiction on CNBC. As previously oil and stocks moved in opposite directions because of shocks to the supply like Katrena and other things. People feared this would cause shocks to production and delivery of goods. This time it is entirely different. Oil prices are rising because of very strong global demand, caused by very strong global economic growth. Again that is not my explanation but the one I just heard on CNBC.
At any rate the stock market reflects expectations! It does not reflect the current situation except to the extent that the current situation influences future expectations. The price of oil is currently influencing the economy but not to any dramatic extent. People expect oil prices will fall, but not by very much. They obviously expect the stock market to continue to rise. And as noted above, the oil market is in backwardation meaning traders expect oil prices to fall in the future.
Expectations do not necessarily reflect future reality however.
Ron Patterson
Think of the stock market as the floor drain in a slaughterhouse. The blood comes from an ever increasing supply of cattle (money). The fed has quit posting the M3, the primary indicator of money supply, because they are printing money as fast as they can. This money has to go somewhere. I can tell you that is no longer going to the housing bubble. It has never gone to the people who actually need it, the poor and lower middle class or even the middle class. It goes to the rich. The rich are already rich, but they are greedy monkeys and they will never turn down practically free cash. So, they park their money in the stock market.
Meanwhile, the plunge protection team, using Uncle Sam's printing presses buys up the market whenever it looks like it is about to tank. For a prime example, look at GM. It is essentially bankrupt, yet its stock continues to hold and even rise. This constant infusion of cash into the hands of the rich is exactly what is levitating the markets.
We essentially have a Zombie Market. It is the undead market. How long can this last? As long as people continue to believe that the US government gives a rat's ass about the people. As long as the rest of the world will let the US get away with it. (there are signs that the rest of the world has had it with supporting the US's free ride. Once the oil producing countries decide to quit accepting the dollar, you will see the value of the dollar collapse.) When this happens, all the funny money in the stock market will flee en masse to countries with stable currencies (if there are any). Of course, these countries will demand far more dollars than they would yen or other currencies to buy equivalent stocks, bonds and currencies. It will be pretty much like Weimar Germany's hyperinflation with dirt poor millionaires buying loaves of bread with wheel barrows filled with cash.
If we had not shipped most of our major industry overseas in a fit of greed and stupidity, we might be able to recover in a relatively short time. But, we cannot time travel and kill off the moronic, greed-head traitors who saw fit to gut the heart of America. We are stuck with their evil works. When we can no longer afford to buy our cheap crap, haute couture, common tools, shoes, medical equipment and everything else necessary for life from China, we will find ourselves scrounging for clothes, food, shoes, shelter, and clean water. We will end up like so many people living on the fringes of capitalist society, like people in Manila and Guatemala City. We will be digging through our garbage heaps looking for a pair of shoes, for clothing, for anything still viable and we will starve.
So, to continue the image from above. The blood swirling down the drain is the life's blood of our country. It is your future, your children's future and their children's children's children's future. It will mean the effective destruction of the US.
There are rough times ahead. The neocons on the site will pop a vein about what I've just said because they are the cause of this coming misery and they are just beginning to realize it at a basic level. Some of those cretins will do the right thing and grab their right to bear arms luger and blow their brains out. Others will see it as an opportunity to profit from our destruction. And the vast majority of them will continue to believe their own BS because they had to be awfully stupid to believe the claptrap to begin with. And they will fight to the death to preserve the right of the rich to ruin our country, rape our environment, and enrich themselves at the expense of the hoi polloi.
The blood swirls counter-clockwise and we keep standing knee deep in our own blood.
And why do you believe, that only USA is going to tank? Why should For example Europe manage it so much better?
You may want to notice my parenthetical remark about stable currencies. (if there are any)
Yes, there could be global meltdown. I can hardly see that as a good thing or even a different thing as far as the US's collapse is concerned.
I suspect that the US will be the first to fall. If others fall as well, ho hum. Welcome to the club.
Or, as Vonnegut says, so it goes.
The US first? I'm not so sure. The dollar is not available for carrying at 0.5%. If Japan would raise its interest rates, which it will have to at some point, the Yen would be dead in the water, the carry traders would be forced to jumo ship real fast. That's a mighty fine conundrum in Tokyo. Dead if you do, deceasad if you don't.
I'm guessing the blast will start in Asia. Could be Japan, or Shanghai, or even somewhere smaller like Thailand, rippling through to bigger markets.
There is a huge speculative bubble in China at the moment too.
But as for Japan, why would they do this? If they destroy the yen then the dollar falls anyway if this theory is correct because once the yen collapses there will be no global flow of liquidity anyway.
Ghawar Is Dying as we slide Into the Grey Zone
"The greatest shortcoming of the human race is our inability to understand the exponential function.
Your argument correctly implies that it is Japan and China that have the option to make the call as they hold enormous U$S reserves. This is the relevant point.
The US has no option.
Well it has the option to do the right thing and massively raise interest rates, but there isn't anyone with the ballz to do it. The medicine is too bitter.
I suspect that China will attempt to maintain BAU until after next year's Olympic Games in Beijing. The games are of huge financial, cultural and "prestige" importance to the Chinese authorities, and are likely to be the last "Great Games" of the modern Olympiad. London in 2012 might not even get to the starting blocks. Although it might well be better for China to pull the plug now on the US bankruptcy, I believe they will try "save face" for another year, and then let the crash happen. Just one more "above ground" situation to add to the mix.
I am not at all convinced that China wants to "pull the plug" on the US. Like a dealer, China has no incentive to stop supplying his addict. He just has to make sure that he doesn't hold the paper from the addict too long. And more to the point, China has found an outlet for dollars - Africa, used to buy real physical resources and access to resources. It's the foolish tinpot dictators of Africa who think they are getting rich (and they are at the moment). Of course even a few of them are not stupid and are reinvesting those dollars in military hardware or other physical goods. But the vast bulk of Africanized dollars end up in Swiss bank accounts where they will eventually be worthless. And that's good for the US too. While the US tries to keep the velocity of money high amongst consumers, there could be an argument made that a certain subset of the dollars of the world are better off at rest because then they represent no threat to anyone.
My point is that human greed is incredibly inventive and that the existing financial system is more likely to mutate and survive than automatically collapse right away. I don't think the existing financial system will survive ultimately but it's going to take a few decades to take it all apart, barring anything short of a full scale thermonuclear war.
Like I've said before, while many of you are looking for the dollar collapse, I think there is still a reasonable probability of at least one more credit bubble. And I personally believe the next one is in carbon credits because they are so poorly understood, because the market is so new, both of which mean the carbon credit market will be wide open to abuse and manipulation.
Ghawar Is Dying as we slide Into the Grey Zone
"The greatest shortcoming of the human race is our inability to understand the exponential function.
Hi Grey,
I like your reasoning here - about the "resting dollars".
1) re: "Of course even a few of them are not stupid and are reinvesting those dollars in military hardware or other physical goods."
I just have to add "ouch" on the military hardware. I see it as something that doesn't rise to the level of the word "investment", let alone "not stupid".
2) "But the vast bulk of Africanized dollars end up in Swiss bank accounts where they will eventually be worthless. And that's good for the US too. While the US tries to keep the velocity of money high amongst consumers, there could be an argument made that a certain subset of the dollars of the world are better off at rest because then they represent no threat to anyone."
"Better" - yes. (A welcome smile.) May they rest long, esp. if they can't be used for organic agriculture conversion, putting in place the legal rights of women and children, etc.
3) Which brings to mind a funny (odd) thing. It's tragic, really, the different kinds of "threat" and how they interact with each other.
Where something threatens someone's self-image, and the defense against that threat - which is essentially a non-material threat to an intangible construct - ends up having the result of the injury or death of another, for example.
Pride hurt, pick up the gun kind of thing.
Because here in Europe we have what are called politicians.
They are people who have not starred in movies, or have IQ's lower than 50 and generally don't believe in god:-)
Right,. let's see here.
Blair, Chirac, Prodi, Merkel, Berlusconi, Schröder, Sarkozy, Balkenende, you'd trust them all to babysit your first-born, and not sell her off to the highest bidder.
Huh! Eh! I don´t know what to say. Better lieve it without any more comments.
Yep. you win.!
But...I would trust Alex Salmond . Come on the Scots!!! SNP have even got a bit about peak oil on their webiste (well, used to). We talk a mean game and we've fire in our kilts. (Hey i'm scots Italian!)
Our UK politicians can debate we'll. Black is white. I've seen it first hand. These guys are too prude/classy for any hollwood showman shit.
What am I talking about?
Oh yes Oil. Norht sea. Oh bugger.
Marco.
And don't dare forget our kinsmen George Galloway and Tommy Sherradin. These guys have made our court's witch hunters look like absolute fools. I would love to see a debate between these guys and Bush.
Bush"hey guys who runs Scotland these days"
Tommy:"The McDonalds ye fuc**n'i ejit"
Bush: "Great burgers"
Galloway:"Fascist imperiast pigs that company. But..The've started running thier fleet on the oil from the chip pans. Oil for food"
Tommy: " Aye, Galloway. Oil for food. That rings a bell.
Bush:"Say Galloway, you sure made our court jesters look good in that oil for food trial thing.
George Galloway:"I was tryting to rebuid Iraq and look what you did"
Bush: "Yeah our embassy is 110 acres. "
Tommy: "Ye'll drown in yer own blood nazi B***stard."
if your (european) politicians dont believe in god, they are a whole lot smarter than typical american politicians.
bush draws a majority of his support from neocon jews, uncle tom blacks and hispanics, toothless rednecks and clueless bible believers.
This is a good discussion and basically, I think other powerhouse countries (Russia, China, India, even Western Europe) are playing chicken with the US. "If you guys are going to print more money, then so will we." To keep the system running, all players have to play along and create credit and wealth out of thin air. This could go on a long time until someone flinches and calls in the cards to see what hand is being held by the other players.
If everyone plays nice and keeps the game going, then we may see no economic collapse of the big guns even in the face of very high crude prices. The smaller players will suffer and already are, but they are outliers when analyzing the wealth of the world (in the eyes of the big players...not me).
So far, I think BushCo has convinced the likes of Russia, China, and India to stay in the game, but we have seen some cracks in the loyalty of the players to the game under BushCo rules. You can bet alternative plans have been mapped out under the radar on how to move away from US economic dominance. I believe these alternative plans will materialize way before massive crude production declines become widely apparent outside our little community.
DragonFly41, I think Warren Buffet summed it up well...'When the tide goes out we will find out who has been swimming naked.'
the trouble is ... there will be no other currency to trust or lean on after the $-collapse - THAT will be the paradigm shift itself - and the financial-world already knows this.
I have a hunch - this is actually what it is all about today .... pushing this crude reality to the very end of the line .
The US will never - ever be able to payback its debt - THAT NUMBER IS IMPOSSIBLE (!) ... every american new-born is born with the cost(debt) of a norwegian-apartement atop of its narrow shoulders ... poore little thing...
The question is - Will there be a reverse Marshall plan ? , I guess not and probably we will all be part of the stew - but one should never quit hoping...
BTW- and on behalf of Norwegian citizens - cheers to the US for this graceful Marshall-endowment "beamed upon us", in the aftermath of WW2 :) - it is not forgotten even as Im from the 1960's and after WW2.
AND reality is the Iraqi youths will never ever forget the fact thet the US went to Iraq for some reason eigther - thats another story though ...
Hi Paal,
Well, to your astute observations, may I add a bit of wishful/idealistic thinking,
re: "The US will never - ever be able to payback its debt..."
1) Immediate conservation - enforcement of the speed limit, no new roads, etc.
2) Rail.
3) Massive investment in solar and wind, research.
4) Investment in women's legal rights, education and access to health care.
5) Immediate project to implement Alan's national non-GHG grid, and add to this, switch to strictly renewable for water transport and storage.
6) Conversion of ag to organic.
7) Someone else has to address the finance transition.
All as examples of a "plan" to address "peak".
And export these things at low cost? These things being...
honesty about "peak" ("peak everything"), free sharing of plans and developments...
Oh yes, and out of Iraq, (big etc.). To be replaced w...(?)
Hi Cherenkov,
This is an interesting discussion (as it continues below).
1) re: "If we had not shipped most of our major industry overseas in a fit of greed and stupidity, we might be able to recover in a relatively short time."
This is still possible, in theory, is it not?
If new manufacturing was established in the US, as opposed to any more US (consumer targeted, so to speak) plants in China.
It would be interesting to actually look at what percentages and types of manufacturing went from say, US to Mexico, then shut down in Mexico and gone to China. (Someone, somewhere must know this - ?)
In any case, something short of a complete reversal could still comprise a reversal of trend. (?)
2) "As long as people continue to believe that the US government gives a rat's ass about the people."
OK. Could we get more specific here?
Let's assume *most* people in "gov" are "just doing their jobs" and don't see the big picture. Let's also assume they care, in the sense that people do care. They donate money, they do favors for friends, they care and act when they can.
Who *exactly* has to *stop believing* exactly *what*?
Then, once "they" do, exactly *what* do you want them to do?
I'm serious.
That statement is way too simplistic, it takes a least 2 pages to describe the implications of backwardation vs contango in the oil market. It might be true to say that one component of futures prices is the expected future price, but there are a dozen other factors.
e.g One reason current price may be regarded as too high is because of a record high number of long positions by investment funds.
Short term moves in the market leading to temporary backwardation is pretty meaningless. What is much more significant is the fact that the future prices are much flatter around $70 and are much higher now than was expected by the market say 5 years ago. The market is saying that it expects higher prices.
Yet all futures prices except for the September contract is lower than the current spot price. In that light the above statement makes absolutely no sense whatsoever. No, if traders (the market) really expected prices to be higher next December, or the December following that, then they buy the contract, driving prices up.
For instance, the August 2008 contract is just about $1.00 below the current August contract. If they expected prices to rise, or just hold steady, they could buy that contract, for 4,050 in margin money. That would give them a 25% return on their money in just one year. ($1,000 profit on an investment of $4,050.) If prices rose by as little as $3.00 then traders would double their investment in only one year buy buying that contract. Quite obviously traders do not expect that to happen.
A backwardation in any market always means that traders expect the price of that given commodity to fall.
Yes, it is that simple!
Note: “Traders” and “The Market” are one and the same thing. Floor traders, hedge fund managers, commodity funds and the general public, or those that dabble in commodities, are all “traders” who make up “the market”.
Five years ago, the August 07 contract was somewhere around thirty bucks. Obviously traders did not expect prices to be this high then. As I never tier of saying, expectations of the future seldom match future reality.
Ron Patterson
' A backwardation in any market 'always' means that traders expect the price of that given commodity to fall '
I wish you where a trader mate..I could retire !!!!!
Lets say.. today the prompt market is $74 and $73 next december with a ratable backwardated curve.....
Lets say tomorrow the prompt rallies the $75 and next december is $73.50 with the same ratable curve...
See backwardation is still there, even increased, but the back hasnt 'fallen'
I wrote: ' A backwardation in any market 'always' means that traders expect? the price of that given commodity to fall '
Fletch replied:
And I wish you could read mate, then I would not have to answer such a foolish post.
Question: What, on this thread, have I stressed over and over? It is the fact that expectations of the futures market does not necessarly represent what the market will actually do?
Let me say it again so even those who have trouble reading can understand. The futures market reflects what traders expect that particular commodity to do in the future. If September Corn, or September Crude Oil is higher for the Sep. 07 contract than for the Sep. 08 contract, then traders, on average are expecting Corn, or Crude oil if that is the commodity trading, to be lower next September than this September.
That is just plain down in the dirt common sense. The fact that traders may be entirely wrong in their expectations is another story. After all, they usually are wrong. A commodity very seldom trades, one year later, at the exact price that the futures contract traded at one year earlier.
Ron Patterson
jbunt
Ron - Backwardation does NOT reflect what traders think about the future. When current demand exceeds current supply, people will bid up the current price to entice people to take oil out of storage. [I live in a $200,000 house, and I am not willing to part with it under any circumstances. Okay, I will give you $400,000. SOLD]
In a normal Contango market, people who store the oil want to receive Cost of Money (Interest) + Storage costs. [Your used car is worth $4,000. Okay, I will pay you $4,000, but I will pay you the money in 4 years, and you have to store it and keep it in the same condition. What - now you do not want to sell to me!] So, what does it mean when a market goes into steep contango - traders think that the price is going way up?? NO! It means that the current market is so well supplied that no one wants the oil. Further, although you could make over 20% annualized by storing it, you cannot. Why? Because all of the storage that is available is full. So, do you want to build more storage? Probably not. So you put it into the current market, along with everyone else who does not have storage and take the lower price.
Darwinian is right 100%.
Futures indicate the price in the future (as their name imply) and nothing else. Anybody can jump into the futures markets and buy or sell contracts. So this means that the price for December delivery is the price that market believes will be there in December. If you think that's it's incorrect (say you believe that price will be higher) you can jump in and make a lot of money.
Storage costs that you mention is a way to arbitrage in case of contango. I am pretty sure that contango is not a normal/typical condition. Backwardation would be just as normal. If contago was normal (usual condition) it would make market non efficient. I would gladly help to make markets more efficient by skimming few billions a month.
Going forward, contago might become a norm but only when oil peak comes. In that case contago would indicate that markets anticipates less oil available for sale and thus higher prices.
If there is a contago and if the spread is more then the cost of storing the crude, then it's profitable to store it. But it does not have to be profitable to store crude. There are no companies in the business of storing the crude becasue there is no money to be made (only lose) and that is because contago is not a typical condition.
Jbunt, all you say is perfectly resonable and makes perfect sense. There is just one thing wrong with it. Your theory assumes that people who trade oil futures contracts actually trade oil. Well, perhaps one half of one percent of them do, but that is about all. Some exchanges, like the TOCOM in Tokyo, is cash settlement only. They do not even allow actual delivery of oil.
Today, on just the NYMEX, a total of 563,139 contracts changed hands. That represents a total of 563,139,000 barrels of oil or almost eight times as much oil as was actually produced in all the world. And that does not include the other exchanges around the world. Over all the world well over ten times as much oil is traded as is actually produced.
But of those 563,139 contracts, only a very tiny fraction of them will result in any oil changing hands. Traders go long or short, based not on the cost of storage or delivery but only on the expectation of making a buck. Traders don't really give a damn as to whether storage tanks are full or not unless it affects the price of oil. Then if they do expect it to affect the price of oil, then they will trade according to what they expect that effect to be.
Oil companies, who often hedge, do watch this of course. And they make a tidy profit because the actions of the futures trader often presents a great opportunity for them. However they represent only a tiny fraction of the overall futures market.
I do not deny that storage costs are figured into all this. If it is cheaper to buy future oil than to store it now, this will definitely affect what the hedger does. But the speculator takes all this into account and prices the futures contract accordingly. The speculators, who make up the lions share of all traders, is interested in only one thing...profit! So the price of the futures contract, say one year out, represents what the speculators, taken as a whole, expect the price to be one year out.
It cannot possibly be otherwise. Because if the speculators thought, for whatever reason, that the price of oil would be higher or lower one year hense, then they would buy or sell, in mass, until the price equaled what they expected the price of oil to be one year from now. The speculators do not actually ever buy or sell any oil so they are not concerned with storage costs although they do take into the account that to hedgers this may be of great concern.
One thousand barrels of oil can be bought or sold for $4,010 in margin money, or $3,300 if you are a member of the exchange, as are all floor traders. One dollar movement, in either direction would be a 25% gain or loss. This far outweighs any concern for storage costs in the mind of the speculator. They all are just guessing of course and storage costs figure into their guesswork. But the actual price of the contract represents what the average trader thinks the price of that contract will likely be upon experation.
Ron Patterson
jbunt
Traders (speculaters) provide liquidity to the market. The resulting prices are generally in line with the true market participants - the true hedgers (people who need the product - e.g., Airlines) and the producers. A contango market is the normal state of affairs, because of the discounting mechanism, i.e., interest rates coupled with the storage costs. Producers will "sell" futures on future production when they perceive it to be a reasonable & profitable price, so I will sell it now and produce it later, or when they MUST ensure that they can pay off their obligations, i.e., borrowed money, despite thinking that the price will be higher [because if they are wrong, they are bankrupt - the business equivalent of the death penalty. (I am sure the USC will beat the University of Maine, but will I bet my life on it?)] If you think that oil will be $1,000 bbl in the future, you will buy it now, and build storage. And there is a big difference between saying that you "think" that the price will be something in the future and actually putting your money where your mouth is.
There are a lot of people on this site who are either going to be very, very rich (WTSHTF it will be TEOTWAWKI - so take all of your assets and short the markets) and so the ELP will have no meaning for them, or they are just, in the end, a bunch of windbags along with 99% of the population.
No it can't be. We know that oil prices do not constantly rise month to month. If there was a constant contango then you could always sell future oil. In some cases prices would indeed rise in the next month, thus no profit (or small loss). But very often price would be lower next month (or stay constant) so you could make a big profit. So it can't be in contago constantly. Interest rates would only play a small role here. Future contracts are settled daily so there is relatively little credit risk and one can leverage heavily. If you use 100x leverage, then interest rate can be as low as 5%/100=.05% per year. Trade commissions will probably be larger then interest rate.
I am also not sure that producers need to sell their oil using future contracts. It makes little sense as nobody is trying to control oil price on day-to-day or hour-to-hour level. In other words if say Saudis can't find any buyers for their oil at 80$ per barrel in December, they are not going to cut production to increase the price. Since they will sell at market price anyway there is no reason to see December oil now and not in December. It's not like the price for December oil is necessarily higher then it will be in December. Saudis can sell December oil today if they feel that price for December oil will be lower then market believes it will be, but it will be a pure speculation. Any other country can do the same.
So the price of the futures contract, say one year out, represents what the speculators, taken as a whole, expect the price to be one year out.
Uh not quite.
It means that the number/market power of people who prefer:
Get money $X today, obtain oil sometime between now and one year from now, pay storage costs, make money on investments on $X, and deliver that oil away at some point in the future
is balanced with
Pay money $X today, lose access and interest for such money, obtain oil in one year.
The term structure of futures in nominal dollars must, at minimum, include interest rate expectations during that time.
Higher interest rates of course mean that money owned now (i.e. seller of contract now obtains that money right away) is more valuable than money in the future.
The commercial players in the futures markets do in fact take or provide physical delivery if they can make an extra profit doing so. Unlike stocks, there is a clearer relation to the actual commodity with futures.
In practice NYMEX West Texas is less relevant and deliverable (a pipeline at Cushing Oklahoma) than Brent crude, which I believe is considered deliverable by tanker worldwide.
There was recent pipeline and refinery problems in the regions near the WTI delivery point so that it became less representative of the usual overall oil market. Perhaps these have been fixed and maybe there is additional anomalous demand there now.
Anyway, Brent (worldwide) crude oil was rising well as WTI didn't. Perhaps now the WTI has just caught up?
Global output of low-sulfur crude is down about 1 million barrels a day from a year ago.
http://www.cattlenetwork.com/content.asp?contentid=145158
7/17/2007 8:23:00 AM
ENERGY MATTERS: Real Crude Prices Higher Than Nymex Suggests
First off...I love that the CattleNetwork prints such astute articles about petroleum. I've found many good articles from those guys and for some reason, it just cracks me up. The Supply Chain industry rags also have some good stuff on petroleum analysis. These guys are the industry end users and I feel they are on the front lines and acutely sensitive to what is happening with deliverable petroleum products.
Secondly, this article supports my theory that our US refinery issues and the increase in crude/gasoline is directly related to what the amounts and qualities of crude going into the refinery system. Now Robert has brought out the data showing nothing has changed in this regard, but then I see things like this that say otherwise.
Something is missing in the data we are looking at to analyze what is being run through the refineries and how much of each quality is being run.
Call it my acute intuition or "Spidey Sense", but something has changed in the last year or so in the US refining industry.
Re: The Export Land Model, someone asked the other day about when to start shorting the stocks of companies that own oil tankers. .
http://www.forbes.com/feeds/ap/2007/07/16/ap3918638.html
Associated Press
Sector Glance: Oil Tanker Stocks Fall
Associated Press 07.16.07, 4:25 PM E
VLCC Tanker Rates to Japan Fall About 50% From Last Summer
No collapse forecast as tanker rates fall near year lows
Reuters
Published: July 04, 2007, 00:00
A July 9th Morgan Stanley report called "Global Economics: Oil: revisiting $80/bbl?" has the following quote:
I looked on the Norwegian Energy web site and there appears to be no free information, so i can't get any more details about this quote.
This is the oil that did not leave the the Persian Gulf due to Gonu. Nice to finally see a figure.
Assuming that is true it represents about one day of exports from the Persian gulf.
Saudi Arabia is exporting ~1 mbpd less than last year. The missing oil in transit could be two weeks worth of crude oil that Saudi Arabia can't find customers for.
The middle man is hoarding, trying to keep all his buffers filled. But his buffers are very small compared to throughput so they fail to dampen ups and downs. It's exactly the same as the "branch falling on the wire" in Ohio; no systems resiliency. The result of absent public policy and the maximization of profit.
Hmmmm, in thinking about it and using the electrical grid for analog (electricity on the grid is common-sense fungible) one might expect to hear some advocating for regional energy allocations - the equivalent of cutting the grid.
There would be an energy market separate and discrete for New England vs Mid Atlantic etc....
This world is just not going to hang together.
cfm in Gray, ME
I read it exactly as you wrote it... it was bollocks then and its bollocks now.
The back end of a curve can rise in backwardated market so how are traders 'expecting' the market to fall.. Whether they are right or wrong in hindsight is irrelevant.
Contango and backwardation describes the shape of the curve and the relative strength of the prompt to the deferred.
Not quite. You're ignoring one very significant additional factor - one that affects my (very low level) speculative trades significantly...
'What will the rest of the market do'?
As well as what I think the price of crude will be in Dec 2010 [my preferrred contract currently], my other major concern is what the bulk of other traders think the price of crude will be in 2010 every day between now and then because I don't want a margin call that will force me to sell my home etc etc.
But even more than that, what do other traders think other traders think the Dec 2010 contract will be tomorrow.
As far as I can tell, this matters lots, but only up-close. I can't see ANYTHING that explains the 2010 contract dropping over $1.20/bbl today, can you?
And the thing is, it's quite possible that most, or at least many, folk who sold 2010 today, actually thought the price of crude in 2010 would be much heigher that the ~$72 that it's currently priced at...
But that in no way means that they thought tomorrow it wouldn't be lower, simply because they saw a trend away from contango - simple positive feedback - and so opportunities for more profit somewhere else tomorrow and the next day.
But all of this is short-term, day-to-day, and highly driven (AFAICT) by what's going on around the front few months - If the contract 6 months forward is going down relative to the front month, so will the one 7 months forward. So any speculator holding a contract 8 months out might sell and buy one 2 months out instead.
NOTHING to do with what the price will be in 8 months, all about maximising profit tomorrow.
In the really long term, of course, it all works itself out.
Just like a governor on a steam engine - I can't work that one out in my head either - I mean, it obvious and simple, and it works for obvious and simple reasons - but get up close, try to understand all the self-feedback from instant to instant, ...
[a device I thought my head totally understood until I read Lovelock's 'Revenge of Gaia'
--Jaymax
Jay: If 1. I actually thought that a realization of peak oil would rattle the financial markets big time and 2. I was in charge of the PPT, I would be allocating a large portion of my gigantic available funds to hammering the far out future crude prices. Seems like the best bang for the buck-definitely reassures the sheeple.
There's nothing like a little backwardation to wring out excess barrels in storage, all users not needing crude immediately will buy the futures instead of spot. The change, which I too did not notice, strongly implies falling spot as buyers adjust their buying. As the change is recent, it is not clear that current spot prices properly reflect demand, and in fact we can expect buying to be less than consumption as stocks drain down, and meanwhile oecd stocks are in good shape (the market is amply supplied).
OTOH, IEA, anticipating higher demand, says we need more opec oil right now... imo the future remains murky.
Why were there stock piles of gold? Why stock piles of gem diamonds? Gem diamonds were about useless. If you crush a diamond into fine powder it can be burned in a candle flame. Coal is cheaper.
If high prices cause decrease in oil demand that might cause a slowdown in orders. With a down trend in oil prices there might be a desire to liquidate inventory until the low inventories cause a need for people to order more oil. If there is evidence of widespread shortages people will want to hold oil and sell at a higher price.
Look at real estate. People held it while it was going up in value. Now that it keeps going down in value, they cannot get rid of it fast enough. More houses for sale this month than six months ago, in some areas. The average asking price is lower as lowering prices is one way to sell a house. Offering a free microwave oven is not incentive enough.
There has been the theory put forth that the currently high crude inventories are due at least in part to the contango in the crude market. Crude buyers stock up on the stuff when they expect a higher future price.
If this theory is true, we might see a drop in inventories if crude buyers expect lower prices in the future.
Stay tuned.....
The Summer Highs in the price of Oil--which conform to a seasonal pattern going back over 20 years--have, in the last 2 Summers, converted the Contango along the length of the curve, to Backwardation. And then, in early Winter, as the front part of the curve has weakened, the curve has moved back into Contango.
As the term structure of the crude oil futures curve is at least as discussion-worthy as that of interest rates, there are no doubt myriad things one can say about all of this. Given that, I will just share how I see this phenomenon in our current period in simple terms: the back end of the curve is less volatile, does indeed attempt now to price in depletion, but, tends to be a source of funds for short-term speculation in the front end of the curve. Basically, my view is that currently the front end is seasonal, and the back end is a longer-term structural view.
Per seasonality, the present Backwardation should reach its zenith sometime towards the end of September. Of course, all the traders know this, so, why wait? We may see the high very soon. I would then expect a process to unfold over 3-6 months, where the Contango is restored, at least by the typical seasonal low in February.
Finally, whenever one attempts to say something about the Crude Oil futures curve, usually important commentary gets excluded. The curve is both a reflection of, but also an inducement to, behavior.
Here is a 23 year seasonal chart of the price of oil:
http://www.321energy.com/editorials/hoye/hoye062007g.gif
Best,
Gregor
Nota Bene: for readers new to this subject, the seasonal pattern in the price of oil, and, the crude oil futures curve going out 8 years are two very different things. The above chart is the seasonal price, only. If someone has a bloomberg terminal, perhaps they could throw up today's WTIC or Brent curves for all to see.
Hi Gregor
thanks very much for posting that graph of oil price seasonality. Do you know if the average price of oil stocks also reflects this seasonality? One would assume it would? Is there a graph around which analyses this? Thanks andy
I'm missing something...
Shouldn't a graph of seasonality end with the line leaving the right-hand end of the graph leading into the line on the left side of the graph?
--
Jaymax
Hi Ron.
Isn't it true that futures markets don't in fact predict future prices if there is a "carry forward" mechanism available. In the oil markets this would be simple storage.
The formula is future price = spot price + cost of carry.
If the futures price differs from this I can arbitrage the difference and make a profit. The comment "a demand driven market" makes sense in this context.
Tim.
Tim, no one, to my knowledge anyway, really believes that the futures market predicts anything except traders expectations.
But see my answer to Jbunt and hifisoftware's reply to him also...above.
The true formula for the price of a futures contract=Scratch your ass, purse your lips, and guess. Actually there is no formula, not one that actually works anyway. The price of a futures contract reflects what traders, on average, taken as a whole, expect the price to be in the future.
But I think I already said that didn't I? ;-)
Ron Patterson