Arnold Kling  

Backwardation

PRINT
Gasoline Hysteria... Who is Rich?...

As of May 20th, the June 2004 futures contract for light crude oil was at $41.66, while the June 2005 futures contract was at $35.58. When futures prices are below spot prices, this is known as "backwardation." I believe that it represents a puzzle. Think of it this way. If you have oil, by holding onto it for a year, you are losing 15 percent. That seems kinda dumb.

One argument for a long-term drop in oil prices is that human ingenuity progressively reduces the value of natural resources. However, as Tyler Cowen points out in response to a previous post of mine, anticipated changes in the value of resources should be priced into the market today. If you expect human ingenuity to lower the value of oil in ten years, then that reduces the value of oil right now.

See also Russ Roberts, who correctly factors in expected reductions in extraction costs, although I don't see those falling at 15 percent per year.

Another argument is that when backwardation occurs, inventories drop to near zero, because oil refiners are not stupid--they sell everything they have. Then, because inventories are so low, spot prices go up. Thus, you get a vicious cycle, as argued here.


In 1996, the price volatility was on the upside when tight stocks and the expectation of Iraqi exports encouraged severe backwardation in the crude oil futures markets. The backwardation, by discounting the value of crude oil in the future, discouraged stock building. This kept [near-term] crude oil prices high.

Still, this "backwardation vortex" requires the owners of oil to hold it off the market in order to sell it for a lower price later. Owners would include the Saudis as well as the U.S. Strategic Petroleum reserve.

In addition, the theory that it is thin inventories that cause a near-term price spike would suggest that the U.S. could get considerable leverage out of a sale of oil reserves. Even though our oil sales might be small relative to oil flows, they could be significant relative to oil inventories, which are near zero.

Finally, I was going to argue that instead of a physical reserve of oil, the government (or individuals) could hedge against an oil shortage by purchasing oil futures and options contracts. However, this point was made already by John McCormack, almost ten years ago.


What fixed prices could one lock in today? I conducted an informal survey of swap dealers on November 27, 1995 that indicates prices of about $17.75 for the period 1996-2000 and $18.80 for the period 1996-2005.

This is at a time when spot crude is $18.38. In other words, for many years into the future one can guarantee oneself crude oil prices that are lower than current prices.


For Discussion. Speculators buy low and sell high. The American and Saudi governments do the reverse. Which is the stabilizing force in the oil market?



TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/84
The author at Houston's Clear Thinkers in a related article titled Backwardation of oil prices writes:
    Don't miss Arnold Kling's analysis over at EconLog regarding the phenomenom known as backwardation energy prices. Arnold explains backwardtion by using the example of current and future prices of oil: As of May 20th, the June 2004 futures contract for... [Tracked on May 20, 2004 12:49 PM]
COMMENTS (8 to date)
Bernard Yomtov writes:

Isn't the usual explanation of backwardation simply that hedgers are net short in the market and, being hedgers, are willing to pay a risk premium?

Why isn't that a plausible explanation here? In the immediate run of course it might be sensible to sell off inventories, but what about future production that is not available for delivery today? Wouldn't a producer with oil in the ground that he expected to have available in a year be tempted to sell it in the futures market at a discount to today's high prices?

How quickly can production be geared up in response to high prices?

Bruce Cleaver writes:

Which is the stabilizing influence? Generally, negative feedback is stabilizing, so I would vote for the speculators. The Government introduces positive feedback into the system: as the price increases the Goverment buys more, encouraging further price increases. At low prices, the Government gluts the market, driving prices lower still. I *think* I have that right....

Lawrance George Lux writes:

Governments and Speculators are the destabilizing influence in the first place. There would be no backwardation without the mistaken understanding of market costs by both Speculators and Government. Perfect market understanding, coupled with intelligent market decisions by all, would pattern market prices. lgl

Scott Gustafson writes:

Some background on how fast you can ramp up production.

For each oil reservoir there is an optimal rate at which it can be produced. This rate maximizes production over the life of the reservoir. You can produce slower and still get maximum production. However, if you produce at a higher rate, the reservoir gets damaged and total production falls.

Suppose that you do produce at a slower rate. In economic terms, what that does is extend the production life of the field. Any production you forgo today gets added to the production at the end of the field’s life. For example, if you are 10 years into the production of a field with a 30 year life and you reduce production, you basically add to the production 20 years from now. You don’t add to next year’s potential production.

This explains why most producers produce at the maximum allowable rate for their reservoirs. Income today is worth a lot more than income 10, 20 or 30 years from now (no matter how low the discount rate is.)

If you want future income, you produce today and spend the proceeds on exploration.

For OPEC, the calculation is different. They withhold production today and push the price up. As long as demand is inelastic, their total revenue increases. In the short run supply is also inelastic since OPEC is usually the only one with the potential to rapidly increase production. Most everyone else tends to produce at maximum rates.

Over the longer run both supply and demand become more elastic. OPEC doesn’t want the price to go too high for fear that other production will come online and further reduce their market share.

In short, OPEC can ramp up production in a few weeks. For essentially everyone else, it takes a few years.

Barry Posner writes:

LGL:

Without those "evil" speculators, insurance markets would not exist, and commodity markets (e.g., corn or coffee or pork futures) would not work.

As long as there are people who are willing to trade some money for some certainty, then there will exist people to take the other side of the transaction. The absebce of speculators will increase price volatility.

Jervis Ninehammer writes:

Speculators try to buy low and sell high, but often fail in this effort. The Saudi government arguably does not buy high and sell low, as this would imply they are selling below their cost of production. The American government's goal with the strategic reserve is to avoid disruptions of supply. Supply and demand considerations are the primary stabilizing force in the oil market.

Lawrance George Lux writes:

Barry,
I did not intend to imply that Speculators are evil. They serve a very necessary need of redistributing excess Business profits from those who lack quick utilization, to those who can use those profits for capitalization purposes--whether they are reinvested in the Speculation market or not. These funds eventually fuel capitalization procedures.

What I was trying to say was Backwardation consists solely of a Speculator-generated event, resolved eventually in the Speculation markets. Their rise and fall does not affect real market causation in Pricing, and the free flow of the speculation market will properly redistribute funds, if left alone by Government. lgl

dsquared writes:

When futures prices are below spot prices, this is known as "backwardation." I believe that it represents a puzzle. Think of it this way. If you have oil, by holding onto it for a year, you are losing 15 percent. That seems kinda dumb.

A certain degree of backwardation is normal (hence the phrase "normal backwardation"). It represents the time value of money; if I'm putting down money today for oil to be delivered in a year's time, some of the 15% is my compensation for the interest I could have earned by investing the cash and buying spot in a year's time.

Comments for this entry have been closed
Return to top