Long-Term Pricing Of Oil

Here’s an email that asks a question other readers may also have:

Hi Jim,
I’m a regular reader of your site. I enjoy all the interesting articles that you compile and write about.
I’ve read Profit from the Peak, View from the Top and all about oil megaprojects.
What I don’t understand is why the oil futures, priced out all the way to 2016, could be trading for so little. If peak oil is really coming in a few years wouldn’t the futures market show some hint of it?   (think of all the big money involved, you would think some would go to studying future oil prices)
But the market doesn’t. The market only gives Light Sweet Crude a 15% premium for delivery in 2016. http://www.nymex.com/lsco_fut_csf.aspx
Help me understand why you think the market is so wrong.
thanks, Evan

Futures prices are tied to the spot price and each expiration date price of a futures contract is necessarily tied to the preceding expiration price.  That’s because if the price at a given date gets too far away from that at a nearby date an arbitrageur will buy the cheap one and sell the expensive one until the prices do become close enough.   So the curve is like a line that ties a boat to a dock.  The height of one piece of the line is controlled by the over-all shape of the  line and the shape can never get very steep.

Longer term prices can be higher than spot, which is called contango or lower which is called backwardization.  They generally reflect traders’ opinions of the future direction of oil prices.  The current contago is seen to reflect positive long term expectations.

Another way that long dated futures can reflect optimism or pessimism is in the pricing of put and call options on the longer dated futures.  Those premiums on calls were very small when I first started buying long dated calls in 2007.   They became much greater at the height of the recent oil price expansion.

I agree with the general premise of your question, that the current price of longer dated futures, especially 2011 - 2015, is going to look like a huge bargain by the time we get there.  The problem with simply buying a futures contract for delivery in, say, 2015 is that since it is tied to the spot price, it will decline if the spot price does and if it does decline you will have to post more collateral.  So it could become very expensive to just “hold on until we get there”.

I sold all of my oil futures calls when oil was in the $130’s but unfortunately I then bought some back. My sense is that the price of oil still has further to fall during the current down draft.  I continue to own the calls I bought at higher prices and I intend to buy more at some point, but I am holding off for now.   My sense is that the best opportunity for buying more oil futures calls will be 6 - 12 months from here because it seems likely that the real economy will be undergoing substantial weakness for another year or two that will result in periods of general pessimism about the future price of oil.  That is when I want to load up on long dated calls.

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