Has Peak Oil--As a Meme--"Tipped"? (Out of Futures Backwardation and into Contango)
Posted by jeffvail on May 19, 2008 - 10:00am
Topic: Economics/Finance
Tags: backwardation, contango, oil futures, Peak Oil Meme [list all tags]
Has Peak Oil, as a meme, "tipped"? Our latest oil price poll suggests that well over 70% of the sample (N>3000 now) thinks that oil will at least stay above $114 a barrel for the next two months--and almost half think it will hit $140 a barrel in that timeframe. Search volume on Google for the term is up dramatically in the past month, as is traffic at The Oil Drum. One indicator of a "tipping point" for acceptance of Peak Oil may be the state of backwardation in oil futures. I first raised this idea over 2 years ago, but recent market movements, coinciding with attention in the press, may be validating it: when the markets accept Peak Oil, we will see the end of backwardation in crude oil markets, and possibly even Contango. Here's what has happened over the past 6 weeks:
UPDATE: Graph updated with data as of 10:00am EST on May 19th to show significant contango
A few quick definitions: Backwardation is when prices in the future are lower than in the present. Contago is the reverse, where future prices are higher than in the present.
Normally, oil markets are in backwardation. It is conventional wisdom that oil markets will always return to backwardation for several reasons:
- The Hotelling Rule, e.g. the expectation that improved technology will lead to ever lower extraction costs (which, of course, Peak Oil theory rejects, and in fact argues for the opposite)
- The vicious cycle theory (.pdf): when backwardation reaches zero, there is no incentive to hold inventory of oil, which then causes inventory to decrease, which then causes spot prices to rise, resulting in increased backwardation
- There is no incentive to fix current prices at today's price, because the time-value-of-money would actually result in you paying more than today's price for oil (which only makes sense if you accept that Peak Oil will likely lead to dramatically higher prices in the future)
- Arbitrage (discussed below)
Is contango even possible in oil markets? The conventional wisdom is no, at least not over a sustained period of time. The theory behind this is that if oil is selling for more two years in the future than it is today, then producers will use arbitrage. They'll buy a front-month oil future, sell a distant-month oil future, pocket the difference, take delivery of the front month oil and store it for delivery at the later date. This prevents oil in the future for selling for any more than the cost of storage of oil until that date, and when time-value-of-money is accounted for, that usually requires that future oil sell for less than spot oil.
Contango could exist if a few circumstances were met: present rate of oil production would need to be effectively fixed, there would need to be a consensus that future rate of production will be lower and that demand will remain highly inelastic, and there must be some impediment to storing today's oil to sell in the future. If all three of these came to pass, then the oil markets could be in significant contango and arbitrage would not be able to remedy the situation. Of course, it seems unlikely that these things (specifically the inability to store oil) will come to pass unless through some kind of political or regulatory move, but it is possible.
Because backwardation is the norm, and contango seems unlikely, I think it is highly significant that oil has gone from very large backwardation to nearly zero backwardation over just the last 6 weeks. It seems consistent to me with an emergence of Peak Oil awareness in the markets that led the market to the rejection of every reason for "normal backwardation" listed above except arbitrage (which can only maintain backwardation equal to the difference between storage cost and time-value-of-money).
It's common for backwardation to decrease rapidly in an environment of declining spot prices, but to my knowledge there has never been a decrease in backwardation as dramatic as we've seen in the past weeks in an environment of rising spot prices. I think it's something that requires explanation, and a growing acceptance of peak oil by the markets seems like the most valid explanation. And for that reason, I think the recent decrease in backwardation is, itself, an indicator of exactly that dawning awareness...
Jeff - well done.
Actually, your graph cuts off in 2015. There are crude oil futures through Dec 2016, which actually ARE in contango vs current month (Dec 2016 closed Friday at 126.64 +$5.34 vs Jun 2008 which closed up $2.17 at $126.29.
Still cheaper than orange juice (but now more expensive than kool-aid).
Nate, Tradingcharts.com only carries the NYMEX Crude Oil (Light) contract out to December 2015. Can you give us the URL for whomever carries the December 2016 contract. Thanks,
Ron Patterson
http://quotes.ino.com/exchanges/?r=NYMEX_CL
Thanks Marvin, just noticed the last trade for the December 2016 contract was $130.35, up $3.71 on the day.
Ron Patterson
Kudos for a fantastic analysis.
Ron,
You can get the full spread of quotes (out to Dec. 2016) direct from the NYMEX at:
http://www.nymex.com/lsco_pre_agree.aspx
At the morning, we are now in contango from Dec. 2011 on, with Dec. 2011 at $126.90, Dec. 2012 at 127.41, Dec. 2013 at 128.05, Dec. 2014 at 128.50, Dec. 2015 at $129.15, and Dec. 2016 at $127.40, and front month at $126.86.
Looks like I need to update the chart!
Jeff,
Thanks for the article especially the definitions. Can you (or anyone else) please explain how one would go about buying an option or where i can find this out, Oil Trading 101? For example:
Who or what are the counterparties = who are the trades done with? No point doing the trade if the counterparty cannot deliver.
I remember reading when $100 was first broken the trader bought the minimum quantity, 1,000 barrels? so presumably trades are in multiples of 1,000 barrels.
If I buy an option to purchase 1,000 barrels at $129.15 for Dec 2015 how much does this cost 1,000 x 129.15? Is a set percentage paid for the option and how much margin is required to guard against a falling price?
Is any acccount taken for inflation or a collapsing dollar? What would happen if oil were to be priced in gold or Ameros or Euros...
Does one have to take delivery of the oil or is there something similar to Contracts For Difference in the FX market where you just pay/receive the loss/profit?
Tony: I'd recommend talking to a full service commodities broker for advice on this--if you tell them how much money you want to invest, how much risk you're willing to accept, and where you think oil prices will be at X date in the future with what degree of confidence, they should be able to provide a good buy recommendation. In general, oil futures control 1000 barrels of oil, and require a margin (how much money you need to put up) of about $9000. Then, for every dollar it goes up (assuming you're long) you get $1000 deposited in your margin account at the end of the day, and every dollar it goes down you have to put $1000 into your margin account (if it falls below the maintenance requirement--about $7000). So, the problem with futures is that you can lose more than you put up in the first place. Options, on the other hand, can never lose more money than you paid to buy them (assuming you're the option holder, not the seller). So, for example, if you bought a December 2010 call option with a strike price of $150 for $3,000, and oil went to $200/barrel by the expiration date, then your option would be worth $50,000 at the expiration date. If oil was still at $130/barrel at the expiration date, your option would expire worthless. Generally you won't take delivery--you'll sell the option (or future) prior to that point. That's a very bare-bones, simplified explanation--there's lots more information available online, but I'd still recommend talking to a full-service broker until you feel confident enough in your understanding of how the markets work to trade on your own via an online broker.
Jeff, many thanks for your explanation.
I wasn't originally thinking about trading as never done anything with commodities was more interested in how it worked, but a call option might be a bit of fun instead of buying a red Ferrari:-)
If you're just interested in a wildly speculative "bet," then you can probably pick up a call option on December 2010 oil at a strike price of $250/barrel for under $5,000...
Therefore it will soon make sense to refine orange juice?
Only if you subsidize the sugar that would have to be added. Unfortunately, if energized OJ is used in a low compression engine, the sugar crystals tend to form scorch deposits around the exhaust valves, which in turn causes a loss of
credibilitycompression.I read this analysis over at The Daily Reckoning:-"Why the Oil Price Will Correct Itself"
http://www.dailyreckoning.com.au/oil-price-7/2008/05/16/
Short quote from that article's conclusion:
"Some take measures to avoid using it. Some find substitutes. Some increase production. Markets still work, in other words. Every bubble eventually finds its pin. The day can't be too far off when the price of oil will fall back under $100."
That sounds like one part misunderstanding the root of the problem (he never mentions Peak Oil or any notion of supply constraints), one part faith ("Markets still work" . . . "can't be too far off"). Nor does he mention inelasticity of demand. As with most pundits, I'd say put your money where your mouth is--if an oil price correction "can't" be too far away, how many long-dated put options does the guy own?
He's not really a pundit. He spends lots of time talking about how the markets are not working. My take is that he focuses more on gold, currencies, and debt. If he looses any money betting against oil, he'll probably make it back in his own field, but I wouldn't expect him to be short, certainly not much. (I don't read his column much so feel free to correct me.) But I agree that he does not seem to be thinking about peak oil. I think there are many people who compare this time to the seventies, and expect it to pass.
Beware, the oil price can still fall but we use less if we are in a contracting economy.
Peak oil means less oil supplied/demanded each year post peak - when looked at from the 'less demanded' point of view implies ongoing world recession.
If no adequate alternatives can be found the cost of oil will rise as a percentage of income (GDP), but may fall in absolute terms if demand is less than possible supply - IMO what 'net export' oil market remains will still match supply and demand by price (unless there is a breakdown of law and order and the market is no longer 'free'.)
Post peak oil I don't think you can predict the 'net export' price any more than you can now (so the futures market is still gambling!)
You can expect just an undulating recession - the world economy always contracting, sometimes more than others - and not everywhere in the world will have less access to oil than it needs to expand their local economy - chose where you want to live with care.
Yes, but demand destruction may not occur as fast as crude depletion and hoarding, which could mean prices continue to increase in spite of reduced demand, resulting from dramatically reduced supply.
Demand is always destroyed by supply depletion.
Or are you suggesting that somehow we'll be able to consume some kind of a "virtual" oil?
Economics is such bull excrement. If I cannot buy something it does not mean I do not still want it, and it certainly doesn't mean I don't need it if it's central to my existence.
Demand destruction is a stupid term. It should pply only to wants, not needs. When it is needs, ability to buy is destroyed, not the need to. Flight to an alternative and/or getting fired/not eating, etc., is what it is.
We should be more careful about how we talk about things. Intellectual gymnastics should not be allowed to gloss over human misery.
/rant
Cheers
luisdias, so you're saying then that if food became too expensive people would stop buying it? In what form would the sustinance come from for the nutrition your body craved in the face of starvation, resulting from the need to prove that demand is "always" destroyed by supply depletion? No, you'd be paying whatever the price was and be thankful as hell you had something to scarf down.
Very unfortunately, that is not always possible.
No doubt if you have the money, there is plenty of food in Haiti.
Unfortunately most simply have not got it, and so they eat mud biscuits.
For oil, at some point most will simply not be able to afford it, and that is why I think that oil prices at some point, perhaps $300-500/barrel, will simply not be able to buy the oil, and so price in my view is unlikely to rise above that.
The demand destruction will stabilise the price.
Cslater8, as Dave Mart says demand cannot exceed supply no matter what the price or whether you want or need it - hence several tens of thousands of people will die of starvation somewhere in the world today even though they may well have money in their pockets - there isn't always an adequate alternative.
If hoarding of oil starts in exporting countries in a big way (like the current hoarding of rice) the net export supply can be expected to fall away very rapidly.
Hoarding is normal human behaviour if is more profitable to act that way, and, at the current oil price acceleration it looks like it is more profitable even for oil companies like Exxon to keep the oil in the ground!
Nobody has any idea what the oil price will be that a poor impoverised OECD person can afford if there is a major resource constraint induced recession - but I suspect limited food (limited by the supply of phosporus and overpopulation) and clean water will take priority over everything else at some point.
So, eventually the price of oil may well be below the current one, people just won't have the money to buy it (as in most parts of the world already.) If you can't afford oil you won't be able to afford the alternatives like electric cars either IMO.
According to Picken on CNBC today oil prices will hit $150/barrel this year, and that can't be supported by the major importing nations, and will result in major depression until alternatives are found and used.
Higher prices in Europe in the past were a result of national taxation, and the money did not leave the economy.
IOW the effects I speculated on with oil at $3-500/barrel will actually hit at a lower price level, and next year.
He feels that not even $100/barrel is sustainable by importing economies, so even after demand destruction has reduced use below the 85 million barrels a day we can produce and prices drop, demand will not be stimulated.
It would just mean that oil exporting countries would have no incentive to hoard their asset as that too would be devaluing, but will not be able to afford so many imports as their impoverished customers will not be able to afford it.
This will further hit world economic demand.
Just means we are running out of sellers at the later dates..
As more and more energy companies become peak oil aware less want to be short 2016.. and lock in there price. More and more consumption companies and speculators want to be long, as they become Peak oil aware. Thus contango. NG has been in contango many times as has gold for years. There is no evidence that oil cannot be traded in contango. In fact if you look at gold and NG Contango is the normal state of affairs.
I agree that there's no evidence that oil cannot be traded in contango--today's prices are pretty clear on that. However, there are still powerful market forces that push back against contango. If a producer can sell oil for more in 2015, after accounting for cost of storage and time-value-of-money, than they can in the present, then they will do so.
This is true of any storable commodity. The big difference between oil and gold/natural gas, to the best of my knowledge, is cost of storage. I don't have good numbers for price of storage of gold off hand, but in many geological formations natural gas storage can be accomplished for very, very little and is routinely done on site (and there is a very large amount of NG storage available because it is a more seasonal commodity, at least in the US). For those who must store produced oil, as opposed to storing oil via shutting in production, the cost of storage is quite significant. I think this makes the shift to contango even more significant... does it suggest that those countries capable of shutting in production (e.g. OPEC) are doing so as they have lower cost of effective storage? Not sure...
But how can there be storage if it's taking everything possible to keep the markets supplied now?
Mac, there is always storage. Last week, in the US, it was 325.8 million barrels or 22 days supply. That is right in the middle of the five year average. There must be storage in case of any disruptions happened, hurricanes, war, etc. the refineries would not run out of oil.
This Week in Petroleum
Ron Patterson
I suspect some industrial consumers of oil are starting to store (hoard) the stuff, presumably as refined products.
They are now doing this, I'm guessing, not to turn a profit or save money later, but rather to hedge against the possibility of shortages. For many companies, the monetary value of any difference in prices (whether plus or minus) is trivial compared to the consequences of running short.
If many customers worldwide are doing even a little bit of hoarding, that could easily explain the recent rise in price. (Trading of futures, on the other hand, should not significantly alter the price of physical goods.)
I question any commodity storage figures going out 4 digits.
And 22 days supply is only based on stable pricing.
I posit that we are at MOL.
That inventories aren't keeping up and that is why we have backwardation.
Actuals are dictating the price.
Just an opinion of another oil user.
You're assuming that the goal of the market is to keep buyers supplied. This is incorrect--the goal is to make money. If sellers can make more money by selling their oil later as opposed to right now, they will do so, no matter how dire the present shortage.
This is one reason why unregulated markets should never be used for things like emergency medical care.
The goal of the market is to allocate scarce resources. It does so on based on price. If there are shortages, then the price will rise to communicate such shortages. At that time, the hoarder can quantify it is worth the current spot price or more or less. He can then make another decision to sell or hold.
So our current unregulated health care system functions why? What stops a doctor from charging one person their life savings to save their life? - Another doctor who does it for less...health care would take care of itself it was UNREGULATED and allowed to compete against each other. Instead you've got a few companies lobbying the $hit out of Congress to maintain status quo. For that you get stuck with whoever YOUR employer chooses, not you. Great system.
Regards,
TFD
UNREGULATED health care - hmmmm. I don't know. I kinda like doctors who have to go to medical school, but thats just me.
Um, Cheapest form of storage is leaving it in the ground. It still seems to me the national oil companies are the only sentient energy institutions.
There are more logical errors (and ideological errors) in this than one has time to write about. Market forces don't work in the delivery of any essential services (I offer Enron as an example), least of all health care, because of infinite inelasticity, and not the least a social policy imperative supported by all reasonable people, that health care availability should not be dependent on your capacity to pay "market price".
A national insurance scheme is the best policy, and not that difficult to implement. Then you also have to regulate how often doctors should be able to upgrade the Porsche.
I wasn't clear, my mistake. Unregulated in the fact that anyone can claim to be a doctor is not what I meant. Unregulated in that you are not forced to use what your employer chooses for you. There is a third party making an individual's choice and we all complain because none of the choices seem palatable. So why are we asking for another third party to make that choice once again? You can't handle the freedom to make your own choice? I don't get it. Elaborate because I'm missing something. PM me if you so choose, but I seek the same goal its the means to that end up for discussion.
There is a lack of choice. You get to choose between possibly two providers selected by your income source. If instead, we would be able to shop against each other and get perhaps a corresponding tax break to offset the cost (dont like this either but I'm trying to compromise), we, the patient, would be at a net gain based on competition for our dollars.
This is basic competition and trying to institute some government program that wont work only serves to distort a free market more. When will people understand the totality of man's choices? We've seen how this has progressed and the solution every time is more government. Really? Thats what we need. We need more taken from us, to even things out. That's grand if we are lowering all of our standards in the process.
Jeff,
FYI, gold can be insured and stored quite cheaply say at around 0.2% of the cost per year. This is stored at a reputable bullion dealer vaults around the world in stable countries (so no need to hold it in your own country especially if they have a history of confiscating gold). This supposes you have bought the gold from the dealer.
Since one ounce of gold costs about eight barrels of oil it needs a somewhat smaller space to store and won't run all over the floor or catch fire:-)
The size of the storage required is what has always puzzled me about speculators driving up the price. Since one day's supply of 80 million barrels would more than circle the world standing up, to significantly affect the price huge amounts of storage would be required other than leaving it in the ground of course. So on this basis alone I can't see speculation as the culprit, maybe that's why it is a good target for politicians coz there's nobody to hit back:-)
Jeff, nice work.
I bought my first contract on 15 May 2004. It was a Dec 2008 for $29.50/bbl. I told the broker it would go to $80/bbl before it expired. He laughed.
Over the last 4 years, I have been waiting for two things to happen to indicate to me that people/investors/etc were becoming Peak Oil Aware: 1) When the price of the out most years rose above the preceding contract years, and 2) when the out years went contango.
Number 1 happened in Oct 2007, number 2 is happening today. All the out years are up $3+/bbl, while the front month is up ~$0.70/bbl. So 2011/2012 to 2016 are now higher than the front month.
Hmmm, if this sticks, then would oil producers want to cut production so they can produce more in the future at the higher prices?
"...if this sticks, then would oil producers want to cut production so they can produce more in the future at higher prices?"
That pretty much sums up the vicious cycle argument noted above: IF producers can get more money for a contract in the future (counting time-value-of-money and storage cost if they can't effectively shut in the oil) than they can now, then they should do so--and to the extent that they are corporations governed by US law, they have a fiduciary duty to their shareholders to do so.
The problem the, is that this would significantly reduce present inventories, and presumably cause the spot price to shoot up, erasing the contango. It will be interesting to see what happens.
The real issues, in my mind (and this also addresses Starvin Marven's comment above) are:
1. Can production be effectively shut in, or must it be produced and then stored. Many national oil companies may be able to merely shut in production, but domestically where a lease applies, or internationally with a PSA, there may be serious complications. Producing the oil and then storing it costs money and, presumably, would be reflected in a build-out of storage facilities or an increase in storage rates.
2. Diversification. In less geopolitically stable regions, producing the oil now and selling it now so it can go into your particular royal family's diversified overseas bank accounts has more value than the potential to sell that oil for more in the future, assuming you're still in charge...
Hello Jeff,
Regarding Step 2. Diversification....
Ye Olde Medieval King's Castle & Forest updated. IMO, I would expect their Sovereign Investment Funds [SIFs] to move into premium farmland, fertilizers, seed companies, grain elevators, purchasing water rights, building luxury Eco-Tech Bunkers, etc.
Storing energy in I-NPK is concentrated and cost effective. Recall the posting of 3 gallons of gasoline equivalent per 40 lb bag...and you cannot eat crude.
Imagine telling your postPeak peasantry, "Behave, or I won't sell you the farming inputs..."
Bob Shaw in Phx,Az Are Humans Smarter than Yeast?
I believe that most of the "sellers" of long-term future contracts are the producers. They will not stop producing today for many reasons, like: (1) send their employees home for 5 years; (2) politics; (3) violence perpertated by other humans; (4) most wells have royalty and joint interest owners who would all sue; (5) reserve and field management, (6) most leases are "held by production" so that if they do not produce for a certain period, they revert back to the landowner; (7)etc. The producers just sell their future production today on the NYMEX to lock in the higher future prices. The buyers of long-term futures are primarily users who are concerned that prices will be even higher, and some specs who are hoping for a profit. Thus, if PO is really beleived, the market should go into contango - but that also depends upon the pain if present shortages develop because some users would be willing to pay almost anything to keep their supply.
Which brings me around to rationing whenever peak oil is an accepted fact and there is not enough in the present to go around. The theory will be, that rationing makes sense while at the same time governments around the world will unite to find alternatives - kind of like the space station, etc.