The Futures Market is the Price-Discovery Mechanism for Oil

Following up on my previous post mocking the Political Class' assertion that greedy speculation is at the root of high oil prices, I also must critique the other end of the opinion continuum that assigns trivial influence of future expectations on spot pricing.

Writes Michael S. Rozeff:

The fact of the matter is that the futures price is connected to the current spot price for immediate delivery. It is impossible for the futures price to get too far above spot. It cannot get above it by more than the cost of carry. Otherwise traders will buy spot and carry the commodity while selling the futures contract. This will lock in an arbitrage profit.

Technically, quite true, but Rozeff has the tail wagging the dog, assuming that the Spot market is the price discovery mechanism for oil and treating Futures Contracts as mere Forward Contracts. However, the actual fact is that the Futures market long ago supplanted the spot market as the price discovery mechanism for oil, and Rozeff's explanation of arbitrage only demonstrates why the spot prices align with expectations. This isn't conjecture but a matter of common knowledge. OPEC and the other petroleum exporting countries for some time have relied on the Futures Markets for price signaling (e.g., IPE Brent Weighted Average) after deeming spot market exchanges too illiquid and prone to manipulation. You can argue whether expectations are rational or not, but expectations nonetheless drive spot prices.

From 2000- 2005, OPEC used Expected Prices (i.e., price signaling from the Futures Markets) to set production level output to maintain a price range zone. However, after 2005, OPEC essentially lost it's ability to manage/counter expectations via production output because of increase in excess supply capacity utilization(that is, a very tight market with low spare capacity) and increased uncertainty (risk premium) in expected prices. The US invasion of Iraq served to exacerbate the former (invading Iraq in already tightening market and subsequently taking Iraqi production offline) and is the primary contributor to the latter.

Maybe you can answer this question for me:

As the price of oil has been shooting up, I constantly hear references to the prices of oil for 6-month delivery (I think that's the timeframe). I wonder why they focus on that, because I wouldn't consider that to be the "real" price that determines the price of consumer goods like gasoline. Shouldn't we be focusing on the spot price?

As I understand the situation (and what you wrote above), the six-month futures price will include a risk premium that is absent in the spot price (when supply may be disrupted in the next six months, it's worth paying a few extra bucks to be assured of delivery, but once that time has passed and we see that supply hasn't been disrupted, we find that we have more oil that we feared that we would, and prices should drop).

So, are gasoline prices determined by futures prices, or by the spot prices? If it is the spot prices, then why does everyone focus on the futures prices.

P.S. Are people carrying oil? I was under the impression that carrying oil is very expensive.

the spot markets trade on that basis. If the futures price gets out of whack with spot delivery prices, then players would arbitrage by buying short term-forward delivery contracts in the spot market(e.g Brent Crude) and selling Brent Crude futures at the IntercontinentalExchange. However, the Futures Exchanges are way more voluminous and liquid than the spot market exchanges, which means the Spot price ends up essentially pegged to the futures price.

Since the spot price is the futures price(minus cost to carry transaction costs), the spot price reflects the risk premium. So when, for example, the Bush administration threatens to bomb Iran, increased uncertainty(risk premium associated with future supply and demand) can be incorporated fairly quickly into current gas prices.

The whole back and forth on "speculators" driving up the price of oil (either good or bad) is getting old. I think it's impossible to argue that oil isn't being driven up by investors. I think this is also perfectly defendable as investors flee to a commodity that certainly seems more secure compared to, say, the decline of the dollar. But I do think that we may be experiencing a bubble in the oil market, where people are over-estimating the extent that oil will go up and continue to go up, regardless of shifts in demand. The big question is when do we see the bubble burst.

If I've got this right, the cost of carry will decrease as investment opportunities dry up, because it will decrease the cost of financing the ownership of oil through the carry. This will bring spot prices and futures prices closer together...but will that increase spot prices or lower future prices (or both)?

That's what one economist wrote:

The authors conclude that if Congress wants to restrain speculation, regulators "should keep the shorter-term futures contracts and eliminate the more speculative six months futures contracts."

They way I'm interpreting this is:

Futures$ <= Spot$ + Carry$

However, I hear that the right answer is

Futures$ = Spot$ + Carry$

I think the problem is that I'm viewing the Carry price as being >= 0$, and the total quantity being carried to be something >= 0 barrels.

So what happens if we expect a new supplier to come online in 3 months? It seems that futures prices should drop some. This could provide relief today if it reduces the carry quantity (i.e. we start consuming stored up oil). However, if the carry quantity hits zero then this strategy is no long available and spot prices are no longer tied to futures prices. The futures prices can continue to drop without the spot prices being affected, and likewise, they can rise without affecting the spot prices until the difference exceeds the carry cost again.

So which equation is correct, the first or the second?

For some reason, I think you are being bogged down by the idea of "cost to carry." Cost of carry is just a transaction cost equal to to the time value of money over the period of the forward contract in the spot market and the cost of storage. It's never going to be zero. But even if transactions costs were zero, it would have no bearing on the main argument.

The main argument:
If future supply-demand expectations result in a change in the futures price ,then by arbitrage the spot price will change to the futures price minus costs of carry(transaction costs). Price discovery takes place in the futures market and is a much more liquid market than the spot market.

It's actually the reverse arbitrage that gets me. I'm looking around for something that clearly describes how these financial activities interact with the actual production/consumption/storage of the commodity.

One author suggested that "cost of carry" could effectively be negative, if the "convenience yield" (or something) is greater than the storage costs.

Whether the market is in backwardation or the normal "contango" condition doesn't have any real bearing IMHO (that futures is the price discovery mechanism for oil) unless it get's really out of whack...mild backwardation signifies for whatever reason, efficient/perfect arbitrage is not taking place, but it's not enough of a counter-argument against the fact the Oil Exporting countries have specific policy to rely on Futures for pricing. Plus, backwardation is supposed to be a sellers market, but spot crude has been dropping with futures the past week.