Arnold Kling  

If I Thought Oil Prices Would Eventually Fall

Arbitrage Challenge... Regulatory Hindsight and the H...

Bryan asks if it is possible to profit from unique knowledge that oil prices will start to fall in three years, given that futures markets only go out three years.

I would not call it a sure bet, but if I held those beliefs, then I would take what I believe is called a "short spread" position in the futures market. That is, I would take a short position in the futures contract that expires 36 months from now (June 2011), but I would hedge against near-term noise by taking a long position in, say, the contract that expires 6 months from now (December 2008). As a result, I am short the "spread" between the 36-month price and the 6-month price. Every six months, I would roll this position forward, so that in December I would unwind my position and short the December 2011 contract while buying the June 2009 contract. Rinse and repeat until the market begins to see the light and the short position starts to appreciate relative to the long position.

I am not making that bet today, and I would not. See Yves Smith on the perils of trying to estimate oil production capacity. Pointer from Mark Thoma.

Tyler Cowen comments on Bryan's question and other oil-related issues.

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COMMENTS (4 to date)
JPC writes:

Both AK's and Tyler's solutions are wrong. The short dated futures won't change in price at all as longer dated spot forecasts change. When the new futures are listed they will immediately reflect the future spot price expectations. The only way to profit is if after a contract is listed, and before it's expiration, the new information hits the market. That was not the premise of the question, which held that spot prices would be flat for 5 yrs, would fall after that, and that the market would catch on in one year. Since the market catches on before futures contracts are listed for the time frame the price will change, no arbitrage possible, as the newly listed contracts will contain the new price expectation, and the previously listed contracts contain the unchanged old expectation.

Bryan Caplan writes:

Could you go back to my specific example, Arnold? To clarify the issue, I specified a precise timeline where the rest of the market suddenly catches on at the end of year 1. How would your approach help you in that scenario?

Arnold Kling writes:

If the market is going to figure things out suddenly, then one day I could wake up with the entire array of futures prices changed, and I have not made any money. That's a valid theoretical possibility. In that case, I would have been better off taking a naked short position and rolling it over every few months. So the latter strategy I would pick if you hold me to the strict letter of your example.

JPC writes:

That won't work either. You don't make money rolling a short position from a high priced contract to a low priced one. You only make money if, after you have rolled, the price of the contract changes as I outlined above. In Bryan's example that won't happen. The newly listed contracts will immediately trade at the expected lower price.

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