Backwardation

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?

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....

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

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.

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.

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.

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

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.