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Calling oil wrong
Chart of the day - from John Kemp at Sempra Metals:
Here’s an illustration of how the market has consistently called the future price of oil wrong over the past five years - snapshots of forward prices each November, compared with the reality of crude prices. Since 2003 the forward market has persistently ignored the great oil rally.
So if the market has failed to signal real future prices in the recent past, why should we believe that current market indications will prove more accurate?
It’s an important question - especially when policymakers seem to be citing the curve in forward prices as a signal that oil prices will stabilise in the near-term, taking the heat out of inflation, while hard-boiled oil bulls also use the charts to back predictions that crude will remain above $100 for the next decade.
All of which gets right under the skin of Mr Kemp:
The forward curve does not tell you anything about future realised spot prices AND IT DOES NOT PURPORT TO.
He says there is systematic confusion about what forward prices mean.
The forward curve shows you how much you pay to buy crude oil (or any other commodity) at a future date with a price fixed today. It does not show you how much the market thinks that the commodity will actually cost when that future date arrives. There are a whole variety of premiums and discounts built into the futures prices (including cost of carry, convenience yield, investor premium/normal backwardation, and liquidity) that can cause futures prices to diverge substantially from the market’s best guess of the future spot price (and this is unobservable). Because the premiums/discounts are not static, you cannot back the expected future spot price out from the futures prices.
So, to be clear, the forward price is NOT the market’s collective best forecast for the future spot price.
This is a simple point (well understood as long ago as the 1930s by John Maynard Keynes) but which appears to have been unlearned by much of the investment and policymaking communities in recent years.
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tears for tier1: I was using that as an example. When you calculate the forward price you do have to factor storage costs in. And with equity dividends and bonds IR payments. But as an example it illustrates why you would not expect the expected future spot to equal the forward. I am not an expert in oil so I dont know the costs of storage but I think you can pay someone to look after it for you
Monkey
- all true but I always wonder, in commodities such as oil and softs, how do you physically store the stuff for, say 3 years?
Obviously it works with say copper bar etc but with oil is there any way of storing the stuff in very large physical volumes (outside the US strategic reserves) to allow such risk less timing trades.
I always wonder how the so called speculators who are pushing up the price of oil are actually storing it in large enough volumes to make it worth their while.
Only oil well owners can sell these forward long-term contracts without excessive risk?
So one shouldn’t always by the back of the curve based on fundimentals then.
This effect is called normal backwardisation. If you think logically about it it makes sense as the buyer of a forward contract that you receive a premium for taking on the risk. On the other side imagine that you are the holder of the asset (in this case oil) and you sell forward and the forward equalled the expected future spot rate then you would have a riskless position giving a return above the risk free rate (as you will have used a rate above risk-free to calculate your expected future spot rate) - which is nonsensical.
The only forward curve that normally shows only expectations and does not reflect any other factor is that for interest rates on government bills / bonds.
(An expected change in taxation of interest at some point along the curve might be a distortion).