Futures trading isn’t driving prices up

Fallacies about oil futures prices abound. One is that the Arabians bought the futures and sent the prices up so they could sell more oil at higher prices. Which is it? Are they buying or selling? Another is that oil speculators buy and sell from each other in rounds of trading while lifting the price.

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. Oil contracts out to March 2009 are showing this cost of carry situation. On the other hand, the spot price can get higher than the futures price if the existing supply is limited or if the future supply is expected to be large. Oil futures prices start to decline after March 2009.

No sensible speculator will pay prices so high for future delivery that they could have gotten oil cheaper by buying it now and storing it for a few months. The Saudis can’t make any money by bidding the futures price up beyond the cost of carry. Otherwise they will end up taking delivery of high-priced oil, far from being able to sell it t high prices.

Unlike stock prices, which can vary within large bounds because their maturity is infinite and there is nothing necessary to tie down the price (apart from a liquidation or a buyout), futures prices cannot depart from the reality of the spot price very far. That is because in a few months time, the contract matures. And when it does, the futures price converges to the spot price at that date. Hence, the futures price is tied strongly to spot prices.

If oil futures prices are rising, the essential thing is that the spot prices are rising. If oil is expected to be short in the future, then as futures prices rise, it will cause traders to buy in the spot market and store oil. If inventories are not rising, then the latter is not occurring. Reports are that inventories are not rising. This means that futures are rising because the spot prices are rising. It means that demand NOW is meeting lower supply NOW, and that is the proximate cause of the oil price rise.

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4:43 pm on July 15, 2008