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By Jennifer Warren on May 31, 2013 with 1 response

Why Are Oil Futures and Spot Prices Out of Sync?

The Unbearable Lightness of Oil Prices

What could be behind the recent observation that oil futures prices are out of sync with the physical market? It’s true that the U.S. continues its march towards less imports as of the year 2005 to the present, according to the 2013 U.S. Energy Information Administration’s Annual Energy Outlook. At the end of 2012, the U.S. upped its crude oil production to 6.5 million barrels per day, from 5 million in 2008. This U.S. oil supply boon is thanks to our Western producing states plus North Dakota and Texas.  Alongside hydraulic fracturing and horizontal drilling, enhanced recovery methods such as COinjection have played a role in the production gains.

In general, the market is well supplied. As OPEC concluded its May 31 meeting, the cartel is not restricting supply to push up prices in the near term, though some member states would like to. Surprisingly, they have not systematically calculated the impact of U.S. shale oil production vis-à-vis their own members’ production.

A disconnect was emerging however between the oil futures market prices (financial) and the physical market, or spot prices. The U.S. benchmark (WTI) crude-oil futures were up 4.6% since the start of 2013, according to a Wall Street Journal article of May 19, while the futures prices of the global benchmark Brent was down. One analyst suggested that the investment demand for exposure to oil prices was supporting these numbers, not physical demand growth. So what information content is behind oil prices, and how do we parse reality from the hype?

Price Revelations

The idea that excessive speculation drove the oil price spike of 2004-2008 still resounds in some corners, in spite of evidence to the contrary. Expectations regarding crude oil market fundamentals still mattered most, according to research by financial economist James Smith of Southern Methodist University’s Cox School of Business.

The price of oil reveals considerable information. Because of burgeoning Chinese demand and other growth areas during 2000-2009, prices were pushed up and supply did not keep up with demand. In earlier research, Professor Smith highlights that high oil prices resulted from OPEC capacity being low. While oil demand in the advanced economies may now have peaked, the continued growth in demand from developing economies can only be met by increased production from new and unconventional supplies—or by higher prices that moderate it. 

The demand for oil is very inelastic. We will drive our car, to a greater or lesser extent, in spite of price variations. Demand for natural gas is more elastic because power plants can switch off to coal. Inelasticity magnifies differences in expectations, says Smith. But there are also many other fundamental attributes, like the volatility of demand shocks, that impact the ability of the spot market in oil to align expectations of the future. Many market participants don’t have access to specialists’ information or projections, but to some extent that private information is revealed in the spot price. The informed trader reveals his knowledge in the price offered, and by extension, to the general market.

The current spot price of oil tells us what the “smart money” thinks will happen with respect to supply, demand and geopolitics. Iran’s nuclear forays are rolled up into today’s prices as well as expectations about Chinese economic growth and demand. Importantly, Smith noted that “if market participants believe the storable commodity of oil is going to be more valuable next year, and the smart money is aware of that, they will bid up the price.”

It’s Complicated

Pricing crude could become more complicated before getting more simple. We now have key interactions between the Brent benchmark price for most oil traded globally and the WTI (West Texas Intermediate), and between WTI and the LLS, or Louisiana Light Sweet crude oil.

While traders have reacted to the spread between Brent and WTI, the LLS is revealing more “open interest,” an indication that new money is flowing into the marketplace. Trading volumes of LLS contracts, historically trading at 300-350 per day, are trading at 2,000 contracts per day since the beginning of 2013, according to CME Group that oversees the Chicago Merchantile Exchange, the world’s second-largest exchange for futures and options. An analyst from CME notes that the spread between WTI and LLS is a “chief indicator that the substantial increases in onshore U.S. and Canadian production are pricing waterborne barrels in the U.S. Gulf Coast.”

Global Impact

Volumes of U.S. crude supply are displacing imports from West Africa, Algeria and the North Sea. The Nigerian Oil Minister recently said in a conference that the U.S. shale boom could cut revenues by 25% from African oil producers. When viewed from a country-level perspective from one producing region such as West Africa, the U.S. resurgence in oil production is altering trade routes. It will continue to impact prices globally.

Worldwide crude price spreads are expected to tighten. China is looking into alternatives to paying Brent prices. Do these trends have long-term staying power? Hard to say with a multitude of so many variables. In the medium-term, fundamentals point to continued U.S. oil production and demand trends seemingly fluctuating between developed and developing countries. U.S. oil producers will produce at these higher prices however, which appear to be sticky for many reasons.

  1. By special k on June 1, 2013 at 9:35 pm

    Oil pricing worldwide is being investigated by multiple authorities…because there is obvious manipulation worldwide!

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