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58 comments on I think Katrina and Rita got some folks attention

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jhm on October 6, 2005 - 6:09am Permalink | Subthread | Parent | Comments top
The only news, aside from this site, that I hear about crude prices is the 30-day future.  My question: does anybody actually pay this?  It doesn't seem to make sense to buy a 30 day future (assuming you really want to buy the commodity and aren't simply speculating) if you think the price will be higher, so futures would seem to have a built in lowball tendency; how well does the spot market track with the future price of thirty days before?
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pbrewer on October 6, 2005 - 11:50am Permalink | Subthread | Parent | Comments top
The fact is that "futures" prices have almost nothing to do with expectations of future prices.  They are almost entirely determined by interest rates.

Imagine you're a wealthy institution (or individual) with some cash you want to invest.  You could put it into 3-month treasury bills and make 3.5% (annual rate).  Or, you could buy oil on the spot market and (at the same moment) sell a future contract for the same oil 3 months out.  If the three-month future oil price is enough higher than the current price to cover the transaction and storage costs and still return more than the 3.5% annual rate of return, then obviously you want to buy the spot oil and sell the oil future.

Observe that it makes no difference what the price of oil actually is three months from now.  You've locked in your rate of return right at the start.

In practice there are some extra costs and risks.  For example, a hurricane might make it impossible for you to actually deliver the oil you've got sitting in your storage tank.  Then your tank is tied up longer than the 3 months you'd planned (raising your costs) and you're in danger of defaulting on your delivery (if the market doesn't declare force majeure and say you can deliver later).  But that just means that threshold where you make the trade is higher than 3.5%.

You can make the same trade the other direction--you have oil now and you need oil in 3 months.  You can just store your oil for three months, or you can sell it now and invest the cash in treasury bills, while simultaneously buying a futures contract for oil for delivery in three months.  As long as the future price is not so much more than current price that the interest on the treasury bill can't make up the difference, then the trade makes sense.  If you would otherwise have to pay for storage, that's another plus to the trade.

The actual future price of oil has almost nothing to do with it.  It's all a matter of interest rates.

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viget on October 6, 2005 - 12:13pm Permalink | Subthread | Parent | Comments top
So then, the real number we should be concentrating on  is the spot price, no?
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pbrewer on October 6, 2005 - 2:44pm Permalink | Subthread | Parent | Comments top
I think the main reason that people track futures is that the market is very liquid compared to the spot market, so it shows up price changes very quickly.

And there is some information in the futures prices.  When they DO move out of line with what you'd expect based on interest rates, it means something significant is happening in the physical markets, such as a risk of physical shortages severe enough that contracts for delivery can't be met.

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