New Developments in Oil Futures Markets

CEEPR Workshop Cambridge, MA December 2006 New Developments in Oil Futures Markets John E. Parsons Center for Energy and Environmental Policy Research

Front Month, NYMEX-WTI, 1986-2006 $80 $70 $60 $50 $40 $30 $20 $10 $0 Apr-86 Oct-88 Apr-91 Oct-93 Apr-96 Oct-98 Apr-01 Oct-03 Apr-06 2 CEEPR

Historically, Oil Futures are Backwardated $50 $45 $40 August 11, 2004 $35 $30 $25 September 18, 2003 $20 $15 0 2 4 6 8 10 12 April 26, 1999 3 CEEPR

Historically, Oil Futures are Backwardated $50 $45 $40 i.e., distant month contracts are cheaper than near month contracts August 11, 2004 $35 $30 $25 September 18, 2003 $20 $15 0 2 4 6 8 10 12 April 26, 1999 4 CEEPR

Backwardation, Inventory & Convenience Yield if you can manage it, it s cheaper to purchase supplies ahead of time in the futures market and organize operations to use them just in time holding stocks pays a cost above and beyond the simple storage cost Buying at the high spot price, contracting the future sale at the low, distant futures price, and holding the commodity to close out the transaction Buying high, selling low, and paying the storage cost holders of inventories must be earning a return somehow to compensate we infer a high convenience yield to the inventories 5 CEEPR

Backwardation is the Source of Commodity Portfolio Performance Returns Stocks 5.65% avg. risk prem. Comm. 5.23% avg. risk prem. from Facts and Fantasies about Commodity Futures by Gary Gorton and K. Geert Rouwenhorst, 2005 6 CEEPR

Backwardation is the Source of Commodity Portfolio Performance Returns The return on oil has been 10 percentage points higher than the return on the commodity portfolio as a whole. Stocks 5.65% avg. risk prem. Comm. 5.23% avg. risk prem. from Facts and Fantasies about Commodity Futures by Gary Gorton and K. Geert Rouwenhorst, 2005 7 CEEPR

The Creation of Commodity Funds Goldman Sachs created its GSCI in 1991 Collateralized futures: buy 2 nd maturity out and roll when it is the prompt month before delivery dates A diversified commodity index But energy commodities dominate approx 70% of capitalization Within energy crude is 44%, natural gas 9% 8 CEEPR

The Creation of Commodity Funds Goldman Sachs created its GSCI in 1991 Collateralized futures: buy 2 nd maturity out and roll when it is the prompt month before delivery dates A diversified commodity index But energy commodities dominate approx 70% of capitalization Within energy crude is 44%, natural gas 9% Imitated by many others; all major investment institutions such as pension funds, hedge funds, etc. 9 CEEPR

The Creation of Commodity Funds Goldman Sachs created its GSCI in 1991 Collateralized futures: buy 2 nd maturity out and roll when it is the prompt month before delivery dates A diversified commodity index But energy commodities dominate approx 70% of capitalization Within energy crude is 44%, natural gas 9% Imitated by many others; all major investment institutions such as pension funds, hedge funds, etc. Popularity developed in 2003-2004 10 CEEPR

The Creation of Commodity Funds Goldman Sachs created its GSCI in 1991 Collateralized futures: buy 2 nd maturity out and roll when it is the prompt month before delivery dates A diversified commodity index But energy commodities dominate approx 70% of capitalization Within energy crude is 44%, natural gas 9% Imitated by many others; all major investment institutions such as pension funds, hedge funds, etc. Popularity developed in 2003-2004 $40 billion invested, 90% from pension funds 11 CEEPR

The Creation of Commodity Funds Goldman Sachs created its GSCI in 1991 Collateralized futures: buy 2 nd maturity out and roll when it is the prompt month before delivery dates A diversified commodity index But energy commodities dominate approx 70% of capitalization Within energy crude is 44%, natural gas 9% Imitated by many others; all major investment institutions such as pension funds, hedge funds, etc. Popularity developed in 2003-2004 $40 billion invested, 90% from pension funds These now represent nearly 50% of open interest in oil futures 12 CEEPR

Are the Speculators Responsible for the Rise in Oil Prices? a view surprisingly reinforced by BP s CEO, Lord Browne: The Times of London, April 06: Lord Browne blamed [the increase of the crude oil price] on nervousness in the financial markets over the conflict in Iraq and a big increase in activity by speculative financial investors in oil. He said: The scale of this [financial investment] has risen significantly, it has got much larger. We don t know whether it makes things more volatile. It is the case that the price of oil has gone up while nothing has changed physically. 13 CEEPR

Influence Exists September 29, 2006 Goldman Sachs, Sachs, which which runs runs the the largest largest commodity index, index, the the G.S.C.I., said said in in early early August that that it it was was reducing the the index s weighting in in gasoline futures significantly. They They started unwinding their their positions, and and those those other other longs longs also also rushed to to the the door door at at the the same same time, time, said said Lawrence J. J. Goldstein, president of of the the Petroleum Industry Research Foundation. Wholesale prices prices for for New New York York Harbor Harbor unleaded gasoline, the the major major gasoline contract traded traded on on the the New New York York Mercantile Exchange, dropped 18 18 cents cents a gallon gallon on on Aug. Aug. 10, 10, to to $1.9889 a gallon, gallon, a decline of of more more than than 8 percent, and and they they have have dropped further further since since then. then. 14 CEEPR

Influence Exists September 29, 2006 Goldman Sachs, Sachs, which which runs runs the the largest largest commodity index, index, the the G.S.C.I., said said in in early early August that that it it was was reducing the the index s weighting in in gasoline futures significantly. They They started unwinding their their positions, and and those those other other longs longs also also rushed to to the the door door at at the the same same time, time, said said Lawrence J. J. Goldstein, president of of the the Petroleum Industry Research Foundation. Wholesale prices prices for for New New York York Harbor Harbor unleaded gasoline, the the major major gasoline contract traded traded on on the the New New York York Mercantile Exchange, dropped 18 18 cents cents a gallon gallon on on Aug. Aug. 10, 10, to to $1.9889 a gallon, gallon, a decline of of more more than than 8 percent, and and they they have have dropped further further since since then. then. 15 CEEPR

Recently, Oil Futures Moved Into Contango $70 $65 November 22, 2006 $60 $55 $50 $45 $40 August 11, 2004 $35 0 2 4 6 8 10 12 16 CEEPR

This is a Normal, Occasional Phenomenon $80 $70 $60 $50 $40 $30 $20 $10 $0 Apr-86 Oct-88 Apr-91 Oct-93 Apr-96 Oct-98 Apr-01 Oct-03 Apr-06 17 CEEPR

Current Contango Has Been Long-lasting Since Nov 04, two years running in contango out to 12M Previous 5 years, 12M contango less than 9% of the time Mention other notable windows Not just at a trough 18 CEEPR

Long-end of the Curve Used to Rise $30 $28 $26 September 18, 2003 $24 $22 $20 $18 April 26, 1999 $16 $14 $12 $10 0 10 20 30 40 50 60 70 80 90 19 CEEPR

But Now Falls $70 $68 $66 November 22, 2006 $64 $62 $60 $58 $56 $54 $52 $50 0 10 20 30 40 50 60 70 80 90 20 CEEPR

Declining Risk-Neutral Drift? 4% $80 3% $70 2% $60 1% $50 0% $40-1% $30-2% $20-3% $10-4% $0 Apr-86 May-87 Jun-88 Jun-89 Jul-90 Aug-91 Sep-92 Oct-93 Nov-94 Dec-95 Dec-96 Jan-98 Feb-99 Mar-00 Apr-01 May-02 Jun-03 Jul-04 Aug-05 Aug-06 21 CEEPR

Declining Risk-Neutral Drift? 4% $80 3% $70 2% $60 1% $50 0% $40-1% $30-2% $20-3% $10-4% $0 Apr-86 May-87 Jun-88 Jun-89 Jul-90 Aug-91 Sep-92 Oct-93 Nov-94 Dec-95 Dec-96 Jan-98 Feb-99 Mar-00 Apr-01 May-02 Jun-03 Jul-04 Aug-05 Aug-06 22 CEEPR

Volatility Has Not Increased 120% 3-Month Rolling Volatility 100% 80% 60% 40% 1 12 24 20% 0% Apr-86 Oct-88 Apr-91 Oct-93 Apr-96 Oct-98 Apr-01 Oct-03 Apr-06 23 CEEPR

What Can Explain These Phenomena? 24 CEEPR

Model of Futures Prices Futures prices equal the expected spot price But risk-adjusted! Futures prices are the risk-neutral oil price The size of the risk-premia determine how the shape of the futures curve deviates from the shape of the forecasted spot price 25 CEEPR

Determinants of the Shape of the Futures Curve at the Long End Slope (not the level) at the long-end has two elements growth rate in the spot price less the market price of long-term oil factor risk Assuming spot prices are flat or falling in the long-run, then a rising futures curve implies a negative market price of long-term oil factor risk. A shift to a falling futures curve implies a rise in the market price of long-term oil factor risk 26 CEEPR

Determinants of the Shape of the Futures Curve at the Short End The primary factor at the short end is the transient disruptions in the supply-demand balance; is the short-run spot price above or below the long-run trajectory? if above, then it is expected to fall, and futures prices will reflect this and slope downward, if below, then it is expected to rise, and futures prices will reflect this The market price of short-term oil factor risk also enters the equation To get the degree of contango obsered recently, and to get it consistently as the spot price has spike and fallen sharply requires a negative market price of short-term oil factor risk 27 CEEPR

What Can Explain These Phenomena? increasing market price of long-term oil price risk or a shift to a belief in the long-term decline in oil prices declining market price of short-term oil price risk? evidence for inflow of available risk-capital at the short end? evidence is not in the levels, but in the shape of the curve timing is not coincident 28 CEEPR