We’ve touched on the issue of the forward curve not being a forecast a few times on FT Alphaville before.
But just in case it still hasn’t hit home — since many are seemingly still confused — here’s a little more from former energy analyst John Kemp, now a columnist at Reuters, on the matter of what futures curves in commodities tell investors.
First, though, his thoughts on the scale of the misunderstanding:
Policymakers and some commentators continue to display worrying ignorance about how futures prices are formed and what they imply.
In response to questions about the recent surge in oil prices, an IMF spokesman said last week “current market pricing suggests this will be mostly a temporary price shock”. If prices continue to rise due to further supply disruptions the impact on growth could become appreciable “but that is not our or the markets’ expectation”
¡Ay, caramba!
So, while policymakers and forecasters may have a tendency to cite futures prices to justify their beliefs but as Kemp points out this has actually led them to being tripped up repeatedly in the past on their forecasts.
He explains:
Forward prices have been used extensively in macroeconomic models used by central banks and other official agencies. But even a cursory review of the forward curve’s behaviour in recent years shows forward prices have been very poor predictors of realised spot values.
And the reason why futures are so poor at forecasting is because the forward curve shows the price at which it is possible to buy or sell futures contracts for a forward date at a price agreed today.
It is not a forecast of future spot prices.
And that’s because there are other factors impacting futures prices in commodities than just market views.
Namely:
1) Interest rates, storage costs and insurance — also known as the ‘cost of carry’.
2) Tightness in the physical market — also known as the ‘convenience yield’.
3) Physical characteristics of the commodity (whether it is easy to store, whether there are ample inventories etc.)
4) The effect of John Maynard Keynes’ ‘normal backwardation’ theory — which suggests forward prices will always tend to be discounted to the market’s expected future spot price to give investors an incentive to take on risk from producer hedgers. Which means even if the price is estimated correctly, the traded price will tend to under-state the market’s real price forecast.
5) Market liquidity — imperfect liquidity being able to substantially hinder anyone’s ability to buy or sell at the price they believe prices may eventually end up.
6) And finally, the curve fails to account for the ‘real’ inflation-adjusted value.
So as Kemp concludes:
For all these reasons, extracting market expectations about future spot prices from amid all these other influences is exceptionally difficult, it not in fact impossible.
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Given how difficult it is to back out forecasts for future spot prices from the futures and options markets, policymakers would be well advised not to use phrases like “the market expects”.
It is basically meaningless nonsense. But one thing “the market” certainly does not expect is for the current surge in prices to be temporary. If it did, prices would not be here now
Quite.
Related links:
Are the oil thieves actually shrewdies instead? – FT Alphaville
Energy forward curves are tricky for Bloomberg – FT Alphaville
Why the forward curve is NOT a forecast – FT Alphaville Long Room