Oil and the Futures Market


...there should be little contention that the commodity index funds raise futures prices, since buying, holding, and rolling over futures is what they are mandated to do...

...Now that oil is over $140/barrel and everyone has a theory about why the price is so high, I thought I'd join the party and throw in my two cents as well.

First, there should be little contention that the commodity index funds raise futures prices, since buying, holding, and rolling over futures is what they are mandated to do...Commodity index funds tend to buy only the near month contracts (An exception is United States 12 Month Oil Fund LP (USL), which buys one whole year into the future). Therefore, we are probably seeing the combined effects from the index funds and other speculators who either have a view of their own, or are riding on the coattails of the index funds.

For the sake of brevity I'll use the term "speculator" in the rest of this post to describe all those participating in the futures market (with no intention to take delivery) with no regard to their intended holding period or long/short bias...

First, let's recap the facts:

Speculators bid up futures, including long dated futures.

Speculators don't take delivery. There may indeed be hedge funds out there who think about doing this, just as there are rumors that hedge funds are looking into buying grain elevators. For now, I will take the inventory reports at face value. This is a crucial point as we know that the futures market in gold and silver do influence spot prices since a significant portion of physical demand is for investment which depends very much on investor psychology.

The common refrain is that producers have an incentive to produce as much as they can, given a flat futures curve in order to maximize the present value of total return. An example of this is a copper mine. While the spot price, production cost and cutoff grade of the mine might change, the actual copper in the ground is fixed in place. However, an oil field is a far more temperamental beast. If there's anything I learned from Matt Simmons' Twilight in the Desert, it's that the ultimate recoverable resource [URR] of any field is rate dependent, i.e., running too fast a flow rate decreases the URR.

A crude analogy, which is also the extent of my understanding of this issue, is imaging an oil well as a giant straw; the production rate can be increased by increasing the well pressure, commonly achieved by injecting water from underneath the oil layer. However, if the pressure is too high, oil can be driven above the opening of the "straw" and form pockets that are hard to get at, not to mention the water that also is pumped out. In an environment of stable future prices, it is entirely possible that the present value of a mature field is higher if current production is tapered in exchange for a greater URR. Thus, there is potential for a self-reinforcing, running-away train of oil prices. Once again, it's hard to lay the blame on either the speculators who bid up futures or the pre-existing tight supply/demand condition, since both are necessary for this vicious circle to occur.

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