Peak Oil Contango?

Jeff Vail asks the question: Is it possible that a shift in the crude futures market from backwardation to contango indicates that the markets have "tipped" and accepted Peak Oil?

More interesting ideas (and explanations) under the fold.

Contango and backwardation are names for two opposing phenomena in non-perishable futures markets.  Contango is the normal state of most markets, and it describes a situation where the price of a commodity gradually gets more expensive as one looks at more and more distant futures contracts compared to today's spot price.  In theory at least, the level of increase is determined by today's spot price plus the potential arbitrageur's cost of storage and the time-value of money.  Backwardation is the opposite, where the price of a futures contract gets less expensive as one goes farther into the future.  According to economic theorists, backwardation is not normal, and is suggestive of supply insufficiency.  For some time now, crude oil markets have been in backwardation.

Normally when a market switches from temporary backwardation back to contango, it is a result of the short-term supply problem that caused backwardation being resolved--that is, the spot price decreases.  The interesting point from a Peak Oil perspective is this:  a shift in fundamentals, such as a steady decline in world oil production, will make the commodity increasingly expensive in the future and will cause a market in backwardation to shift to contango without a decline in the spot price.  Interestingly, that is exactly what may be unfolding in oil--compare the two graphs below, the first (from Bank of England), showing the crude oil markets in classic backwardation as of Feb. 15th, 2006, and the second showing a potential reversal in backwardation as of Mar. 21st, 2006, especially in the 2009 and 2010 contracts:

Chart 2:  December NYMEX Crude Futures as of market close, March 21st
Click on a chart to see full size.

While the data presented are inconclusive, I think that this theory warrants further analysis--or outright debunking.  Hopefully some TOD readers have access to the kind of economic expertise and historical data to shed some light on the have at it!

(This is Jeff's condensed version for TOD, if you would like to read a bit more of an in-depth post, find it here); also find a discussion of the same topic (in the second half of the post, after an interesting discussion of the memetics of peak oil) at Anthropik.

 The reason for oil to shift back and forth between contango and backwardation is it is highly volatile (politically I mean) and current supply is tight.  When I say that it is tight there is little flex in the market. A single political event or statement psyches out the oil future market (ie Osama releases an audio tape or a terrorist attack). Weather conditions like the previous hurricane season changed prices at the pumps well before any supply difficulties were realized.
  Other future markets like wheat for example are not the subject of debate and scrutiny, and therefore less volatile.  I think when supply is on the decline though there will be one last "flip" to contango.  But that shift still has a few or several years to go.  I work on a drill ship, in a fleet of such ships.  My company is making record profits.  Wells are pumped dry every day but new ones are drilled in deeper and deeper water.

This economic shift in theory would be gradual (see adam smith) it is the political and popular culture that drives the oil futures.

Bingo.  This is a classic case of something we want to measure (the price of oil futures contracts) being heavily influenced by things (natural catastrophes, politics) that are impossible to quantify.

I expect we'll see much greater volatility in the near future, in part because the Bad People have likely figured out how easy it is to cause the West economic pain by staging a high profile (even if unsuccessful) attack on the oil infrastructure.

This this piece on the former Saudi oil minister seems germane to all of this as well...
Until we're all independent of oil?? Is that what he said? When does he expect that to happen--after the dieoff?
The problem with futures is that they are traded NOW.

If I expect resources to be scarce in, say, one to five years, I will be willing to pay more for it NOW. As traders say, it's already in the price.

If the world believes we are past peak, they would be willing to pay 10$ gasoline prices NOW - simply because it will be harder to get in 5 years. That means that the price that it will take to produce the stuff in 5 years are already considered NOW and do not need to be put into the futures' prices which are due in five years. The futures prices will therefore remain a sort of running average of past prices MINUS what you would get by putting your money into bonds.

That is why we see a long period of constant futures in the 1990s for instance. Price went up and down, but the average was mostly the same - thus the futures (five years' difference, for instance) remained mostly the same.

If you see the futures price as "present expectations of the price in the future", you will be led down the wrong path. PRESENT PRICES already have the present expectations of future availability priced in.

If you try to use the future's price to tell us something about the future, you fall into the thought trap that Greenspan fell into a while back - that PO doesn't exist because the future markets don't show it. As he made his comments (not quite two years ago, if I remember correctly), oil was priced somewhere under 40$.

I have to disagree with you on this, as this entire discussion of contango and backwardation is a discussion of exatly when and why futures prices DO NOT remain a "running average of past prices MINUS what you would get by putting your money into bonds."  Futures prices do, in fact, represent the market's expectation of the future equillibrium of supply and demand (price)--if they only represented today's price minus carry cost and bond yield, then they would always be in a formulaic backwardation, and this is definitely not what the price data actually shows.  How, for example, would this "running average minus" maxim account for futures prices being higher in December 2007 than the spot price today?  Just my opinion, but I think that some of the other commentary on this thread has done an excellent job of explaining the real mix between short-term risk and long term supply issues...
Yeah, sorry. Of course there's a premium for futures in the short term (about a year) - otherwise you would be in a deflationary world - buy tomorrow at a cheaper price than today, then you always buy 3-12 months in advance and sell at termin, month for month - a nice arbitrage...

But after that, it's a question of "investment" (speculation) and what's going to give you the most return on your money. In that respect, all investments must be equal. That's why the comparison with the bonds comes in.

Sorry again. I meant "sell at delivery date". German slipped in there somehow.

Anyway, the economist would say there's no free lunch - neither in the short term or in the long term, and the typical curve (Feb. 2005) demonstrates this wisdom.

Contango is not necesarily considered the "normal" state of affairs for all commodities.  Grains are harvested once per year, and in a normal year that supply must be allocated over the coming year.  Higher prices for the contracts late in the crop year are the market's way of encouraging storage.  In a short crop year, price are higher in spot markets and nearby months to discourage storage.

Crude oil, however, is produced continuously.  It is not at all unusual for the crude oil futures market to be in either contango or backwardation.  Both conditions have prevailed for extended periods over the last two decades.  The point still stands, however, that a backwardation reflects a tight current balance between supply and demand that is expected to ease going forward, and a contango would relfect  the opposite situation.

The thing that is most interesting is that the distant contract prices can be interpreted as the market's long run forecast regarding the supply and demand balance.  As such, distant contract prices are much less volatile than spot prices and the prices of nearby contracts, which reflect every short-run production/distribution interruption, the current year's weather, etc.  The market anticipates such short-run issues working themselves out in some limited amount of time.  Distant contracts' prices, by contrast, reflect more signal and less noise.

The prices for delivery of crude oil five years in the future were very stable at around $20 per barrel for most of the history of the NYMEX contract prior to 2003 (I wish I knew how to post a spreadsheet chart that I created that shows this).  Since that time, the five-year forward price has gone up fairly steadily to its current level of around $65 per barrel.  The market concensus regarding the long-run balance betweeen supply and demand is changing substantially.  There is the big story.

I'd love to see that chart.  Perhaps one of the TOD staff could post it for you?  If not, you could send me the spreadsheet and I'll post it.

I agree - it's the rise in distant future price that's a real sea change.  No more "oil will be back down to $20/barrel" any more.  

I don't think that the editors want to do such a thing for everybody.  I looked at your user profile, but did not find an email address.  Email me at subtr4ct-at-gmail-dot-com if you could post the chart and could reply with the Excel file that has the chart.
Okay - I think I figured out how to post the chart...

The prices are for NYMEX crude oil futures contracts delivering about 3 years in the future in the early 1990's, as the futures did not trade 5 years out back then.


Thanks!  Nice chart.  

If the end is chopped off, here's the link to view it directly:

It really spikes up, starting around the beginning of 2005.

That's a great chart, thanks for posting it. It's amazing how flat it is. One question, are the dates shown as the contract delivery dates, or as the trading dates? So for example the firet one, 11/23/1990, is that the price in 1987 for a contract delivering in 1990? Or is it the price in 1990 for a contract delivering in 1993?

It would be great to compare it to then-current oil prices to see how it compares, but I need to know what the dates mean.

Halfin, The dates are the time of trading in the future 5 years forward.
Glad you find the chart interesting.  I first made a chart like this in July of last year, and it led me to really put my money where my mouth is.

The first observation is the settlement price on 11/23/1990 of December 1993 futures.  The last point is yesterday's closing price of Dec. 2011 futures.

Shit! OK, another coffee-spitting moment!

This graph is one of the most compelling illustration of the "Peak Now" that I have seen this year.

This really helps to debunk the view that the current 'plateau' is just another little hiccup in the march on up to 120Mbd in 2030.

Thanks a lot for posting this graph.  I hope Stuart can add this to his "why we're probably peaking now" page.

Sorry.  Go ahead and swollow your current sip...  Okay, the picture for natural gas is very similar:

Note that I have used a dollars per 100,000 BTU price (not the conventional dollars per 1,000,000 BTU price) to make the two series of comparable magnitude.

I don't suppose anyone here thinks the price of oil in 5 years will be anything near $65, which sorta suggests a buying opportunity, or am I reading this wrong?
good buy if you have deep enough pockets and youre patient. long term, i wonder what the chances are of NYMEX ceasing to operate or certain classes of traders being restricted. anyone know what might cause either of these things to happen, besides the obvious 'end of the world' stuff?
I have been wondering this too.  If the market was left to its own devices, I think today's prices for crude five years out are a steal.

But governments could intervene and your options may as well be worthless.  But peak oil in combination with inflationary fighting measures could so devastate the economy (via deflation) that oil five years could cost only half as much as it does today.  But one shouldnt rejoice if average income has fallen to one tenth of today's level.

Has anyone else thought about this?  Peak Oil decimating the economy to the point where the price of oil falls simply because of deflationary pressures (think cascading unemployment reducing demand for virtually everything which in turn reducing pressure on scarce resources). Add in potentially restrictive government restrictions like gold confiscation or protectionist terrifs or high interest rates or permitting employers to unilaterally cut salaries).

Or is the inflationary route pretty much guarenteed?

Deflation is my primary concern, as I have attempted to explain here many times over the last several months. I would expect oil prices to fall (for a while) as a result of severe economic contraction, but I agree with you that purchasing power would be falling even more quickly. Oil would nominally be cheaper, but less affordable than it is now. I don't see deflation as being confined to the US, so a similar dynamic could be widespread.
But governments could intervene and your options may as well be worthless.

What government intervention has been or could be used?

I was just imagining ordering the halt in the trading of oil futures.  Hasn't happened, but it doesnt mean it couldnt.
Can you tell me where (link?) you got the historical prices of the futures contract?  Thanks!
All data in both charts that I posted are from Primark-Datastream, a subscription data service.  I expect that it is fairly expensive, but I don't actually know.  Such data are available from numerous services, however.  I don't of any free sources for historical futures data.
I have the futures data - if you email me I can send it to you
I think that the signal-to-noise concept is very interesting.  Most striking to me is that there is such a jump in near-term futures prices.  At the moment, there is a jump of about $3/barrel from the spot price to the December '06 price, and then a gradual--if uneven--decline each year one goes out beyond '06.  This initial jump makes sense to me, and I think it is the most accurate forecast of the "terror/weather" premium, because a storm or attack is assumed to be a relatively short term interruption.  So for that reason the prices for December delivery are higher, as they incorporate all this noise--political maneuvering, terrorist risk, weather, etc., but the longer-term prices represent the market-consensus on signal--that is, what the future supply/demand fundamentals will look like.

To me, if (or once) the market accepts Peak Oil, then the degree of contango--especially in the 3-5 year out range--will represent the best market information on interaction of declining production and demand destruction.  This will, I'll argue, not actually be "contango" per se, as it will not be caused by the same market forces that cause "standard" contango--it might look more like contango in S&P500 futures back in 1995.  That is to say, it will move upward sharply based on future assumptions of declining production.  If global decline proceeds at 5% beginning now, how much could we expect to see the futures price increase year-on-year?  10%?  I have no idea how to begin calculating this.  It does strike me, though, that contango is constrained at some point by arbitrage:  if contango is at 10% a year moving forwards, that will exert a strong pressure on current spot prices because of increasing demand from arbitrageurs who sell a future, buy and store the oil, and deliver.  Depending on how well inflation risk can be hedged with other instruments, and the performance expectations of other markets, I suspect that contango exceed 15% a year because of arbitrage pressure...  any historical data or thoughts to back up this concept of contango and arbitrage dragging spot prices up by the bootstraps?

I'm sure you're right, Jeff, that the market structure won't allow oil futures to increase too much year over year. If oil producers see that next year's prices are substantially above this year's, it is easy for them to back off on current production in order to have more for next year. That will raise current prices and potentially lower future prices, bringing them back into balance. There is arguably evidence for this behavior today, in terms of OPEC's failure to aggressively invest to increase present-day oil production.

It's harder to say exactly how big the increase could become before this is a major factor. And of course we might see short term fluctuations that are substantially larger. In principle any rate of increase above the prevailing interest rate could trigger the effect (this is the Hotelling model for production of exhaustible resources). That would be 5-6% per year. In practice it could probably be a little more than that but I guess I'd be surprised if it stayed above 10% per year.

Note that this effect looks to the naive eye like greedy speculators are artificially driving prices higher than they should be under conditions of supply and demand. And note too that we have heard exactly this charge in recent months, as oil prices have stayed high despite a short-term glut as evidenced in growing storage inventories. However Hotelling showed that this production profile is actually optimal in terms of maximizing the net economic value of the oil.

We should be glad when this happens; by slowing down current oil consumption we leave more for the future. Some people argue that this is not enough, we should tax it to make it even more expensive, but this is economically inefficient and will cause excess and premature consumption declines. It makes people poorer today and gives them fewer resources with which to deal with future challenges. The best method is to let the market predict future prices, let those future prices drag up today's prices, and trigger conservation on that basis.

The effect should work in the other direction, too, BTW; if future oil prices are not rising at a decent pace (i.e. keeping pace with inflation plus a few percent) then we would expect to see higher production today, leaving less for the future. This effect may have been operating in the past but we will likely see a transition away from it as we approach the peak.

The problem with the argument that speculators will limit the degree of contango by selling the longer term contract and buying the near contract, taking delivery  and storing the oil against their long term short is that few speculators - if any - have the operating ability to take possession of large quantities of oil and keep it stored for years.   Maybe that will develop, but I kinda doubt it.
Interesting to note that backwardation still exists out at 20012, where the Dec. 2012 crude futures on NYMEX are at $63.00.  A reasonable assumption under the peak oil scenario would have priced that distant crude future at a significantly higher price.  Guess not everybody is a TOD'er.  
Disagree - that time scale is long enough for the increased oil price to have caused a major recession, collapsing temporarily the price of oil.  To factor in the risk of this happening is entirely consistant with being a "believer".
From 1972 to 1980 the price of oil went up 9x, causing three recessions. The price never declined yoy during the period.
That second chart up there is pretty misleading because they have only plotted the year-end prices. If someone would go through and fill in the monthly prices, you would see that the second chart still has the same rough shape as the first chart (although somewhat noisier). Prices are generally in contango (increasing) up until the 2007-2008 time frame and then going down. Take a look at a price page like this one and read down the first column:

I made a chart from this data:

As you can see, although it is noisy it does not look too different in shape from the first chart above. So I would not say that circumstances are all that different now.

Actually, I think that this improved chart does--very tentatively--back up my assertion.  On distant contracts in crude, the December contracts seem to be the most liquid--so the best indicator of current market prices.  The December '09, '10, and '11 prices are above the general line, suggesting to me that the more liquid contracts may be moving up in a reflection of expected future higher prices.  The contango that does exist in the '06, '07, and '08 periods I think (as mentioned in comment above) reflects the near term influence of noise and assumed risk, whereas the 3+ year out contracts more accurately reflect the market's future price expectations...  I don't have the data to see if these '09, '10, and '11 December spikes are increasing or shrinking--that might be the most pertinent information at this point.
Just checked on today's CL volume & open interest numbers on NYMEX:
April:  volume 0 / open interest 0
June:  60 / 60
December:  103 / 33855
April:  0 / 0
June:  0 / 0
December:  387 / 22297
April:  0 / 0
June:  0 / 0
December:  328 / 14063
2012: (Only December contract is available)
December:  9 / 5923

Idea for a new measure:  change in spot price as a percent of the change in December future price 4 years out.  The significance is that it may reflect the degree of noise vs. signal of the latest price change...

Another possibility is looking at the standard deviations of changes in the natural logarithms of distant and nearby NYMEX prices.

Using January first observations of nearby and distant contracts (the distant contract is 3 years forward in 1992, moving up to 5 years forward by 1997 when the contracts starting trading that far forward) from 1/1/1992 through 1/1/2006, the nearby changes an average of 40.2% per year while the distant changes an average of 18.9% per year.  

To a large extent, the 18.9% is driven by the recent run up in distant prices that I mentioned above.  Using only data through 1/1/2003, the average annual percnetage changes in price are 44.4% for nearby and 8.5% for distant.

Obviously a contango situation would be the ultimate proof of PO acceptance but the change in long term future prices compared to the change in short term futures is also an interesting meter.

For example at the time of Katrina the near month price was 70 USD and Dec 2008 was at 64. Today the near month price is 63.9 USD but Dec 2008 is at 66.3 (it was above 68 in early March).

My conclusion is that in late August there was a stronger perception of shortage in the short time frame than there is now but now the longer term supply is percieved to be more of a problem. Sounds like peak oil is growing in acceptance (or the new of Burgan and Cantarell)...

For natural gas the picture points even more to PO gaining acceptance...

There is another factor that confounds these observations. When prices move suddenly, long-term futures move less than short-term ones. The result is that the long-term future prices act like something of a "moving average" of the short-term prices. After a sudden move upward, as we saw post-Katrina, long term futures did not move upward as much and we had backwardation. After a sudden move downward, as we have seen occasionally but rarely lately, long term futures do not move down as much and we have contango.

You really need to wait until short term prices have settled down for a week or two before you can say much about the relationship with long term prices. We are in that situation now - prices have been in a channel from 61 to 65 for a month, without much trend - so now we see the classical shape of forward contract prices as shown in the first figure above. But you can't compare with post-Katrina prices, because short-term prices had just shot upward so of course they were above long-term futures.

I disagree with your reasoning Halfin. I the near term market hasn't really been weak lately, as you said its been trading in a narrow band and right now we're closer to the top of that band than the bottom.

My main point is NOT the contango, its the gradual and steady increase in the long term futures...

So, today the market is more worried about long term supply than in August and September. That's my point.

On another note, I have such trouble understanding why the market reacts so negatively to the growth in the so called oil stocks reported weekly.

In a scenario where you (as a commercial user of oil) see increasing prices and perhaps even physical shortages you wouldn't mind growing stocks would you? I think the growing stocks are to be expected in rich countries like yours.

You may be right that the market is more worried now than last year about long term oil supply. The prices are certainly higher. But if you look at the chart for, say, December 2008 oil, the climb has not exactly been "gradual and steady":

It has not been as volatile as short-term futures but it has had its ups and downs. Looking at this chart, one could not be surprised by a drop back to 60 or even 55 later this year.

As far as the question of the market's negative reaction to increasing oil stocks (inventories), I'm not sure what you are referring to. Normally with an increase in inventories you'd expect oil prices to drop, but that hasn't happened. And the overall stock market is doing very well these past few weeks. The only negative reaction I have heard is from bears (with short positions in the market) upset that oil prices are not falling. Their disappointment is understandable but there are clearly good reasons for concern about oil supplies through 2006, even beyond the threat of Peak Oil.

You keep giving yourself away. Would you please stop doing that. For Christ's sake, we don't want to have to cut you loose, man, if that's what it comes down to. But we will. Think about it. You've got much more to gain with us, lad. These clowns got nothin.' C'mon, we'll take care of you.

Cherenkov? You want to go and hang with that lot? He'll just eat you - and burn your boots, no matter what the commie bastard says.

Here's a chart of today's (March 23) closing prices, from the same source. The ones above were the opening prices and were a little ragged.

It looks suspiciously smooth, doesn't it? I wonder if this source is accurately reporting the prices or is interpolating and smoothing them somehow. Anyway this is probably more comparable to the first graph in the blog posting.

BTW where did you get that graph? I read an article a few weeks ago about oil future prices that I think was from the Bank of England. Can't find it now. But it included a graph like this as well as other graphs showing how different commodities tended to look on their forward prices. It was interesting to see that the shapes were quite variable for the different kinds of commodities. Gold goes upsteadily, some of the others are pretty flat, and oil has this up-then-down structure. If you have a link to that original article you should post it, it was good.

Gold is not is short supply, is very easy to store (does not spoil, very compact per dollar of value), and can be borrowed and sold short easily.  This leads to carry-forward and reverse-carry-forward type arbitrage between forward prices being very easy.  Due to these factors, the forward curve for gold is always in contango, and reflects the cost-of-carry (storage costs + the interest that you could be making if you weren't holding a gold inventory).  Trading gold spreads is essentially the same as trading short-term interest rates.

Different commodities have different forward curve characteristics because of they have have different storage, production, and consumption characteristics.  This is the point I was trying to get at above when I was rambling on about grains above...

Reently, at the end of the day, whatever the Dec 06 crude contract is up or down, the NYMEX specialist just changes the Dec 07-Dec2012 strip to be up or down the same amount, presumably because there were few trades late in the day to accurately reflect the late day changes in 2006 liquid contract. (Today they were all up different amounts however)
Here's the link to the Bank of England study of the forward market for oil, which was released as part of its Spring 2006 Quarterly Report (the first graph in this post was taken from this document).

The forward market for oil

As you've alluded to, the study discusses that the 'normal' state of the oil futures market has been backwardation, not contango. For example, whereas gold and silver have been in contango 98%-100% of the time over the past decade, Brent Crude has been in backwardation roughly 75% of the time, and Nymex Light Sweet almost 70%.

From the study:

"One possible reason for a persistently downward sloping oil futures curve would be uncertainty about future demand and supply. Given that one has the choice to delay extraction, in the hope of benefiting from a higher price later, the decision to produce oil when there is uncertainty takes on the characteristic of exercising a financial option -- there is an option value in holding reserves below ground rather than 'disinvesting'. Because the total return of holding oil reserves in the ground includes this option value, the current price must be higher than the price predicted by Hotelling's theory to make a producer indifferent between extracting oil and leaving it in the ground. And if the uncertainty is large enough this can result in backwardation."

Thanks for posting that. Chart A in the box on the 5th page is the one that shows the typical shape of the forward price curve for various commodities. It is interesting to see that oil does typically have the same steep rise and slow fall that we see today.

It's not clear to me whether this shape should be called contango or backwardation. For the most part the curve is down sloping so could be said to be in backwardation. OTOH most of the curve is above current prices so could be called contango.

Chart C on the next page is also quite interesting; it contrasts the futures-market prediction of $60+ with "expert" predictions that show the price falling about $5 per year, down to below $45 by 2010. They come up with some story about how the market could be overestimating prices, but I didn't find it very convincing.

I'm sure most people here will agree with me (this time at least!) that the market at $65 is more likely to be accurate than the experts' $45.

Every expert says something different according to future price. It is just noise. Peak oilers are also noise. If Peak Oil is in the minds of the traders, it is already in the price NOW.

I don't think the market expects falling production just yet. A number of smaller disruptions are in the price, but not permanently falling production. That realization/fact will shake up the markets greatly, changing prices in the present. The basic curve shown above will however remain for futures...

Anybody else see the resemblence to a Hubbert Linearsation?
Seems to me that current inventory levels provide an insight about market participant expectations.

As another poster mentioned, the theoretical maximum difference under contango, between future and present oil prices, represents storage cost plus time-value of money for holding oil during the storage period. Whenever expected future prices begin to exceed present prices by more than this amount, they motivate purchase and storage of spot oil.

Of course, for a producer, one way to "store" oil is simply not to pump it out of the ground in the first place. Thus an expectation of future prices climbing at a rate that exceeds (storage + time-value of $$) raises current prices by reducing current supply.

This suggests that high current inventory levels represent the market's expectation of more expensive oil in the future.

Paul Krugman examined this concept of high prices reducing supply in this article several years ago. Matt Simmons indirectly affirmed this in response to a question I asked at a recent presentation he gave, replying that while he didn't expect producers to "gouge", he did expect them to better shepherd their resources, and gave the example of Kuwait's recent announcement it was reducing production in order to sustain output for longer.

Last week's This Week in Petroleum from EIA had the story line A Buying Spree? At These Prices? and talked about the "deepening contango structure" of the futures market and its impact on inventories:

While it is true that crude oil imports over the past four weeks are down slightly compared to the same period last year, this is happening with crude oil prices $5 to $10 per barrel higher than a year ago, and with crude oil inventories nearly 32 million barrels (more than 10 percent) higher, as well. With prices significantly higher and inventory levels the highest in almost seven years, it may be somewhat surprising that import levels are as high as they are. But to many buyers, $60 crude oil can still be valuable if they expect to be able to sell it later for $65 per barrel, or expect to refine it and sell the refined products for more later in the year. As EIA has written lately, if you expect prices to be higher in the future (due to geopolitical situations in Nigeria, Iran, and other countries; MTBE-to-ethanol transition; ultra-low sulfur diesel fuel; continued strong demand growth; etc.) it can make economic sense to buy now, even if inventories are already high. A deepening contango structure (when prompt prices are less than future deliveries) in crude oil futures markets makes these market expectations transparent and promotes this "buy more now" behavior.
Year on year crude imports may be lower because finished product imports are higher yoy. More refining is done elsewhere such as Canada, Mexico, Saudi, etc.
I just want to add to this interesting discussion that I had posted Predicting Future Oil Prices which is obviously related to this thread.

One thing that I think it is important to point out is the herd mentality of the market and I think futures prices represent something like a new consensus among speculators much like that which obtained between 1986 to about 2002 or so. Future contracts stayed in the $18 to $21 range that whole time. I believe - which was the point of my post - that this "consensus" is stabilizing but at a much higher price.

best, Dave

Several comments:
1)good post and good observation
2)contango isnt necessarily the default structure for futures markets - alot depends on the storability of the product - anecdotal evidence suggests there just isnt the storage capacity for crude oil right now, and the only people who WOULD store it would also be the people who could also refine it - for an airline company what good would it be to store crude, before it was processed into jet fuel? Other products, like gasoline, are hardly storable at all - they go bad after 5-6 months unless they are treated. Gold, on the other hand, is infinitely storable, and the 'carrying cost' is largely the interest rate.

3)During hurricane Katrina I had oil positions on in many contracts - Id have to do some digging to get exact price histories but front month at the time was over $71 while Dec 2009 was $60. Front month and 2009 ARE in backwardation ($63 vs $65). This has happened only in the past couple of weeks. I think youre on to something, but as a previous poster suggested, its one piece of a complicated puzzle.

4)Look at the futures strip for NG - clearly we have tumbled from over $15 for front month down to $7. However, backdated contracts are only $1 off their highs. AND, the entire structure gradually declines until 2011, suggesting that an increase in US LNG is priced in market. Another trend since October is the difference between summer peaks and winter peaks - it has gotten alot narrower, possibly due to expectations of global warmings impact on future demand for NG.

To me the big question is, why does the curve of future contract prices have this shape? As seen in figure 1 above and in my link here of today's prices.

Does it always have this shape? Up and then down? That doesn't seem possible because it would allow a risk-free profit-making spread. Simply go short the month at the peak and go long the month from one year later. This amounts to betting on the difference between the two months, that it will decrease or even reverse.

As the peak moves out from the present day, the near term month will fall and the late term month will rise. It's like a wave moving across the sea. Seems like a guaranteed profit. Since the markets won't normally leave money lying on the table like that, something must be wrong with this strategy.

It could be that it usually works but not always. I've seen a lot of spread strategies that are like that. Usually gasoline and oil move together. Likewise with oil and NG. Usually spring and summer wheat move a certain way relative to each other. Betting on these usual relationships "usually" works.

Except when it doesn't. Sometimes something funny happens and the usual relationships break and stay broken for quite a while. Then all those people happily making regular small sums from their spreads, year after year, lose everything. I wonder if this might be something like that.

I think you nailed it in your last paragraph.

In addition to the astute comments of you and others posted above, I would like to mention the huge wild card of expectations of future inflation.

By implication, it seems to me the futures contracts are assuming inflation over the next several years will average about 3%--what one would expect on the basis of adaptive expectations.

However, a couple of things could happen
1. (very unlikely in my opinion) recession, depression, global deflation or
2. an abrupt upward shift in expectations of future price-level increases when expectations change from adaptive to rational. They can do so in a matter of hours. For example, a crash of the dollar against other currencies accompanied by no action on the part of the Fed to shore up the dollar would trigger a stampede such as we have not seen for many a dollar. (And if we were going into or already in a recession, do you think the Fed would raise interest rates? No way.)

Dlon - Of course no one knows exactly what will happen with inflation, but as you point out the futures markets need some kind of model to work with in order to differentiate true from merely nominal price changes. Supposing that an oil expert does not also want to be an inflation expert, there are a couple of places he can look to find the market consensus on future inflation.

James Hamilton describes the recent record of TIPS, Treasury Inflation Protected Securities, at:

The difference between TIPS yields and regular bond yields produces a prediction of inflation rates over the next 10 years. For a couple of years now it has held steady at 2.5% inflation.

The famous inversion of the yield curve also points towards market expectations of low interest rates, which would tend to be inconsistent with high inflation over the next ten years.

Another place investors could look would be forward gold prices on the futures market. Gold is rising about $30/year for the next several years, corresponding to about a 5% yearly increase. That should put an upper limit on expected inflation.

Of course it is always possible that the markets are wrong and that various bad events such as you describe could lead to hyperinflation or other monetary disasters. The question is what are the chances of these kinds of changes. At this point it doesn't appear that investors are factoring these possibilities into their expectations.

Gold rising by $30 a year does NOT give you expected inflation. It is a mathematical arbitrage of storage costs and short term interest rates - $30 a year exactly equals the interest one would receive for investing $548 for one year plus the storage costs. (Roughly $22 of interest and $8 for storage) If future prices were $50 higher than todays for gold, people could buy spot gold on margin, pay the margin interest rate and short sell next years futures - waiting for convergence would net them $20 in profit per oz. If next years gold price was equal to todays, the reverse trade would make sense.

Oil futures really are their own animal - gold is much more precise mathematically.

The concept of high oil prices causing a huge recession/depression may be at work on the part of the curve after '07 being in backwardation.   The standard wisdom on Wall Street, I believe, is that if oil prices rise a lot, a recession/depression will bring tham back down after a certain lead time.   I'm not sure that won't be the case, either.

My general expectation is that by the time Peak Oil becomes well understood and accepted, as indicated by a front page on Time and Newsweek simultaneously (and with a concomitant rise in the price of crude to over $100 and with vast speculation by the public in oil stocks) there will be a huge recession and there will be the last significant drop in crude prices to ever take place - just enough to really wipe out a lot of the public.   This could take place in 2008 or 2009.   To cement the irony, that may be the exact time when Peak Oil actually occurs.

To me its clear that the market is pricing in geopolitical risk until the peak of the price curve after which point alternative fuels and new production plants come online.

Remember, the market isnt designed to predict scarcity - all it cares about is how much is available in THAT month.

By the way, I just downloaded the last 6 EIA Annual Energy Outlooks since 1999 - they have been wrong (and quite wrong) 6 years in a row regarding prices. Also, not a single major wall st firm has predicted higher prices a year out in the past 6 years. (2006 is the first)

My forecast - front month oil will hit $90 by this summer then be back to $40-$50 next year due to severe demand drop. Next time up in 2008-2009 it hits $200 then drops to $100 after national rationing plan. 2015 its over $500. Thats really not that far away. Of course, why would my forecast be better than our government energy experts or wall st oil analysts? (hint - its free)

It seems like conventional wisdom, even amoung us PO people, that demand destruction is going to help us in our battle against high oil. But if history is any guide, it may be of little help. Consider the 1970s, when the price of oil went from $1.80/bbl to over $18/bbl due to a persistent demand surge. This was a 1000% rise in the price of crude over 10 years. How much demand destruction did this horrific price climb cause? Zip, none. In fact, as Simmons points out (p58,59 in "Twilight") demand actually climbed 44% during this 1000% price climb! That's nearly a 4% compounded per year growth average compared to the 2% rate we're struggling with now. And this was against the backdrop of a really lousy 70s economy compared to the relatively strong world economy today. After 1979, however, the Iran/Iraq supply problems and some more auto fuel efficiency finally leveled off the demand surge. Now we have peak oil to crimp supply and oil at a higher inflation adjusted level than it was at in the early 70s. So maybe we won't have to wait on a 1000% runup to have some cooling of demand. But we always seem to be underestimating what oil demand will be. Three years ago, it was conventional wisdom that oil averaging over $60/bbl would surely cause a recession and demand destruction. Now we've got the $60, but no recession and demand still growing.
"According to economic theorists, backwardation is not normal, and is suggestive of supply insufficiency."

I don't get that at all, why would it be suggestive of supply insufficincy?  Supply < demand should raise prices.

All I can come up with is that "suggestive of supply insufficiency" should read "suggestive of transient supply insufficiency in the spot market."

So it seems to me that backwardization is a signal that market particpants consider the spot market prices as out of wack with their long term expectations and that current shortages are an exceptional rather and a new order.

I would think the market's efficiency would suffer terribly the further into the future it tries to price something. The markets are good about pricing something in the here and now with all the currently avaliable information and outlook, but are not that good a prophet on how all that changes 5 years hence. If you plot up a few oil market prices on the futures chart avoiding noise like the Kuwait invasion and the artificial oil glut of '97-'99 that was just caused by a glut of bad data, it looks something like this:

If the futures market is efficiently calling the pricing 5 years in advance, it totally missed the sharp turn northward '02 to '05. The futures contracts seem to be reacting more to current market pricing than to anything else. In fact, the "futures" look more like a lagging indicator here. I don't know much about futures markets. Do futures contracts do any better for copper, soy beans, or any other commodity?

re: longdated CL futures, i have bought them. i bought many 6yr futures in 2004, at around $27 when front-month was around $38-40. these are now over $60. it is important to understand that the longdated contracts are not very liquid. this is not where a lot of "hot money" is. the vast majority of speculators are working in the first few front months. one theory about why the longdated futes went way up from 03-05 is from Don Coxe--the oil cos experienced big hedge losses in 03/04/05, so they stopped hedging their longdated production. IOW, they stopped selling into the 4/5/6yrs. once the producers are gone, who is going to take the other side of the trade? i.e., if you don't have an oil well in your backyard and you short the 6yr, how do you know what price you can cover at in 2012? you don't know, and do you want to make a naked (unhedged) short going out 6yrs on a commodity that has sextupled in a few years and is widely advertised under the PO banner?

when you consider this point, you will see there are not a lot of people who want to supply (sell) 6yr contracts at even $60. one possible entity that might sell some contracts is a hedge fund who is long an unhedged producer. if the fund thinks the producer is discounting $45 CL (i.e., their stock is priced as if the long-term price of crude is $45) then the fund might hedge the CL exposure by selling $60 longdated CL. in fact just this type of hedge was discussed in the latest issue of Barron's. but i don't think that is a very common trade, even among hedge funds.

so, getting back to the original point, the price action in the longdated contracts doesn't necessarily mean the "all-knowing" market is baking in Peak Oil. rather, the main  "natural" forward sellers--the producers--have stopped selling in size. thus the supply of longdated contracts has decreased relative to their demand at lower price points.

Interesting theory...  Do you have a link to the original statement of this theory, ideally with some supporting data?  Hedgers certainly do get burned on their hedges and receive negative feedback from senior management, boards of directors,  investors, etc.  However, this would need to have happened at most/all large producers for there to be little/no interest in selling at $60 several years forward, especially if they truly believed that the (spot/nearby) price was likely to fall back to, say, $40 by that time.

Also, large hedgers' long open interest (across all NYMEX crude oil contracts - the publicly available data do not break open int. down by delivery month) has been increasing in recent years.  The following chart is assembled from the commitments of traders data available at  For large hedgers to have decreased their long positions in the distant contracts, they would have needed to dramatically increased their long positions in the nearby contracts in order to make the overall average go up significantly.  This is possible, but it is not the most intuitive scenario.

Sorry, I haven't updated these data since I first looked at all of this last summer...

you can read about this theory in Don Coxe's published comments. just Google "Don Coxe Basic Points" and read his monthly Basic Points over the past year. he also has a weekly webcast.
huge hedging losses were very common over the last several years. i don't know of any systematic tallying of the hedges that have come off, but anecdotally i know many cos whose calls i listened to were actively reducing their hedging--not just in CL, but in other products as well. as an example, Valero lost half a bil last year on hedges that they are not putting on this year. a number of cos will have this type of incremental earnings boost due to hedges coming off.
maybe Coxe did some systematic tally. in any case, it is the explanation which makes the most sense to me, based on the limited info out there.
given the current high forward prices, we may be nearing a point where private equity firms would do LBOs of some of the cheaper public cos and take them private. then they would hedge out their production to the extent possible. if enough of this happened, we might see more pressure on the longdated contracts.
also keep in mind that producers are typically going to do their longdated hedges OTC, but intermediaries (their counterparties who buy their forward production) would then be in a position to sell contracts onto the NYMEX.
Since this is open thread, i'll toss this out for thought. Hurricane season starts up first day of June.

When a hurricane enters the Gulf (GOMEX), how quickly will production shut down?

Do they wait till it's within a certain 100 mile range?

How long does it take to "lock down"?

Once the hurricane threat has passed, and no damage has been assessed, how long does it take to restart production?

Throw in political unrest worldwide combined with hurricanes in the gulf. (regardless of category size) I think we'll see gasoline shoot well over $3.50, and oil prices shoot up to upper 70's. I am not an expert, but thats the way i see it happening. Am i the only pessimist?