Peak Oil Contango?
Posted by Prof. Goose on March 23, 2006 - 12:22pm
Topic: Economics/Finance
Tags: backwardation, contango, oil, oil futures, oil prices, peak oil [list all tags]
More interesting ideas (and explanations) under the fold.
Normally when a market switches from temporary backwardation back to contango, it is a result of the short-term supply problem that caused backwardation being resolved--that is, the spot price decreases. The interesting point from a Peak Oil perspective is this: a shift in fundamentals, such as a steady decline in world oil production, will make the commodity increasingly expensive in the future and will cause a market in backwardation to shift to contango without a decline in the spot price. Interestingly, that is exactly what may be unfolding in oil--compare the two graphs below, the first (from Bank of England), showing the crude oil markets in classic backwardation as of Feb. 15th, 2006, and the second showing a potential reversal in backwardation as of Mar. 21st, 2006, especially in the 2009 and 2010 contracts:
Chart 2: December NYMEX Crude Futures as of market close, March 21st
Click on a chart to see full size.
While the data presented are inconclusive, I think that this theory warrants further analysis--or outright debunking. Hopefully some TOD readers have access to the kind of economic expertise and historical data to shed some light on the subject...so have at it!
(This is Jeff's condensed version for TOD, if you would like to read a bit more of an in-depth post, find it here); also find a discussion of the same topic (in the second half of the post, after an interesting discussion of the memetics of peak oil) at Anthropik.
Other future markets like wheat for example are not the subject of debate and scrutiny, and therefore less volatile. I think when supply is on the decline though there will be one last "flip" to contango. But that shift still has a few or several years to go. I work on a drill ship, in a fleet of such ships. My company is making record profits. Wells are pumped dry every day but new ones are drilled in deeper and deeper water.
This economic shift in theory would be gradual (see adam smith) it is the political and popular culture that drives the oil futures.
I expect we'll see much greater volatility in the near future, in part because the Bad People have likely figured out how easy it is to cause the West economic pain by staging a high profile (even if unsuccessful) attack on the oil infrastructure.
If I expect resources to be scarce in, say, one to five years, I will be willing to pay more for it NOW. As traders say, it's already in the price.
If the world believes we are past peak, they would be willing to pay 10$ gasoline prices NOW - simply because it will be harder to get in 5 years. That means that the price that it will take to produce the stuff in 5 years are already considered NOW and do not need to be put into the futures' prices which are due in five years. The futures prices will therefore remain a sort of running average of past prices MINUS what you would get by putting your money into bonds.
That is why we see a long period of constant futures in the 1990s for instance. Price went up and down, but the average was mostly the same - thus the futures (five years' difference, for instance) remained mostly the same.
If you see the futures price as "present expectations of the price in the future", you will be led down the wrong path. PRESENT PRICES already have the present expectations of future availability priced in.
If you try to use the future's price to tell us something about the future, you fall into the thought trap that Greenspan fell into a while back - that PO doesn't exist because the future markets don't show it. As he made his comments (not quite two years ago, if I remember correctly), oil was priced somewhere under 40$.
But after that, it's a question of "investment" (speculation) and what's going to give you the most return on your money. In that respect, all investments must be equal. That's why the comparison with the bonds comes in.
Anyway, the economist would say there's no free lunch - neither in the short term or in the long term, and the typical curve (Feb. 2005) demonstrates this wisdom.
Contango is not necesarily considered the "normal" state of affairs for all commodities. Grains are harvested once per year, and in a normal year that supply must be allocated over the coming year. Higher prices for the contracts late in the crop year are the market's way of encouraging storage. In a short crop year, price are higher in spot markets and nearby months to discourage storage.
Crude oil, however, is produced continuously. It is not at all unusual for the crude oil futures market to be in either contango or backwardation. Both conditions have prevailed for extended periods over the last two decades. The point still stands, however, that a backwardation reflects a tight current balance between supply and demand that is expected to ease going forward, and a contango would relfect the opposite situation.
The thing that is most interesting is that the distant contract prices can be interpreted as the market's long run forecast regarding the supply and demand balance. As such, distant contract prices are much less volatile than spot prices and the prices of nearby contracts, which reflect every short-run production/distribution interruption, the current year's weather, etc. The market anticipates such short-run issues working themselves out in some limited amount of time. Distant contracts' prices, by contrast, reflect more signal and less noise.
The prices for delivery of crude oil five years in the future were very stable at around $20 per barrel for most of the history of the NYMEX contract prior to 2003 (I wish I knew how to post a spreadsheet chart that I created that shows this). Since that time, the five-year forward price has gone up fairly steadily to its current level of around $65 per barrel. The market concensus regarding the long-run balance betweeen supply and demand is changing substantially. There is the big story.
I agree - it's the rise in distant future price that's a real sea change. No more "oil will be back down to $20/barrel" any more.
The prices are for NYMEX crude oil futures contracts delivering about 3 years in the future in the early 1990's, as the futures did not trade 5 years out back then.
subtr4ct
If the end is chopped off, here's the link to view it directly:
http://i78.photobucket.com/albums/j100/subtr4ct/oil.jpg
It really spikes up, starting around the beginning of 2005.
It would be great to compare it to then-current oil prices to see how it compares, but I need to know what the dates mean.
The first observation is the settlement price on 11/23/1990 of December 1993 futures. The last point is yesterday's closing price of Dec. 2011 futures.
This graph is one of the most compelling illustration of the "Peak Now" that I have seen this year.
This really helps to debunk the view that the current 'plateau' is just another little hiccup in the march on up to 120Mbd in 2030.
Thanks a lot for posting this graph. I hope Stuart can add this to his "why we're probably peaking now" page.
Note that I have used a dollars per 100,000 BTU price (not the conventional dollars per 1,000,000 BTU price) to make the two series of comparable magnitude.
But governments could intervene and your options may as well be worthless. But peak oil in combination with inflationary fighting measures could so devastate the economy (via deflation) that oil five years could cost only half as much as it does today. But one shouldnt rejoice if average income has fallen to one tenth of today's level.
Has anyone else thought about this? Peak Oil decimating the economy to the point where the price of oil falls simply because of deflationary pressures (think cascading unemployment reducing demand for virtually everything which in turn reducing pressure on scarce resources). Add in potentially restrictive government restrictions like gold confiscation or protectionist terrifs or high interest rates or permitting employers to unilaterally cut salaries).
Or is the inflationary route pretty much guarenteed?
What government intervention has been or could be used?
To me, if (or once) the market accepts Peak Oil, then the degree of contango--especially in the 3-5 year out range--will represent the best market information on interaction of declining production and demand destruction. This will, I'll argue, not actually be "contango" per se, as it will not be caused by the same market forces that cause "standard" contango--it might look more like contango in S&P500 futures back in 1995. That is to say, it will move upward sharply based on future assumptions of declining production. If global decline proceeds at 5% beginning now, how much could we expect to see the futures price increase year-on-year? 10%? I have no idea how to begin calculating this. It does strike me, though, that contango is constrained at some point by arbitrage: if contango is at 10% a year moving forwards, that will exert a strong pressure on current spot prices because of increasing demand from arbitrageurs who sell a future, buy and store the oil, and deliver. Depending on how well inflation risk can be hedged with other instruments, and the performance expectations of other markets, I suspect that contango exceed 15% a year because of arbitrage pressure... any historical data or thoughts to back up this concept of contango and arbitrage dragging spot prices up by the bootstraps?
It's harder to say exactly how big the increase could become before this is a major factor. And of course we might see short term fluctuations that are substantially larger. In principle any rate of increase above the prevailing interest rate could trigger the effect (this is the Hotelling model for production of exhaustible resources). That would be 5-6% per year. In practice it could probably be a little more than that but I guess I'd be surprised if it stayed above 10% per year.
Note that this effect looks to the naive eye like greedy speculators are artificially driving prices higher than they should be under conditions of supply and demand. And note too that we have heard exactly this charge in recent months, as oil prices have stayed high despite a short-term glut as evidenced in growing storage inventories. However Hotelling showed that this production profile is actually optimal in terms of maximizing the net economic value of the oil.
We should be glad when this happens; by slowing down current oil consumption we leave more for the future. Some people argue that this is not enough, we should tax it to make it even more expensive, but this is economically inefficient and will cause excess and premature consumption declines. It makes people poorer today and gives them fewer resources with which to deal with future challenges. The best method is to let the market predict future prices, let those future prices drag up today's prices, and trigger conservation on that basis.
The effect should work in the other direction, too, BTW; if future oil prices are not rising at a decent pace (i.e. keeping pace with inflation plus a few percent) then we would expect to see higher production today, leaving less for the future. This effect may have been operating in the past but we will likely see a transition away from it as we approach the peak.
http://quotes.ino.com/exchanges/?r=NYMEX_CL
I made a chart from this data:
As you can see, although it is noisy it does not look too different in shape from the first chart above. So I would not say that circumstances are all that different now.
2009:
April: volume 0 / open interest 0
June: 60 / 60
December: 103 / 33855
2010:
April: 0 / 0
June: 0 / 0
December: 387 / 22297
2011:
April: 0 / 0
June: 0 / 0
December: 328 / 14063
2012: (Only December contract is available)
December: 9 / 5923
Idea for a new measure: change in spot price as a percent of the change in December future price 4 years out. The significance is that it may reflect the degree of noise vs. signal of the latest price change...
Using January first observations of nearby and distant contracts (the distant contract is 3 years forward in 1992, moving up to 5 years forward by 1997 when the contracts starting trading that far forward) from 1/1/1992 through 1/1/2006, the nearby changes an average of 40.2% per year while the distant changes an average of 18.9% per year.
To a large extent, the 18.9% is driven by the recent run up in distant prices that I mentioned above. Using only data through 1/1/2003, the average annual percnetage changes in price are 44.4% for nearby and 8.5% for distant.
For example at the time of Katrina the near month price was 70 USD and Dec 2008 was at 64. Today the near month price is 63.9 USD but Dec 2008 is at 66.3 (it was above 68 in early March).
My conclusion is that in late August there was a stronger perception of shortage in the short time frame than there is now but now the longer term supply is percieved to be more of a problem. Sounds like peak oil is growing in acceptance (or the new of Burgan and Cantarell)...
For natural gas the picture points even more to PO gaining acceptance...
You really need to wait until short term prices have settled down for a week or two before you can say much about the relationship with long term prices. We are in that situation now - prices have been in a channel from 61 to 65 for a month, without much trend - so now we see the classical shape of forward contract prices as shown in the first figure above. But you can't compare with post-Katrina prices, because short-term prices had just shot upward so of course they were above long-term futures.
My main point is NOT the contango, its the gradual and steady increase in the long term futures...
So, today the market is more worried about long term supply than in August and September. That's my point.
On another note, I have such trouble understanding why the market reacts so negatively to the growth in the so called oil stocks reported weekly.
In a scenario where you (as a commercial user of oil) see increasing prices and perhaps even physical shortages you wouldn't mind growing stocks would you? I think the growing stocks are to be expected in rich countries like yours.