Why are Oil Futures so Undervalued?

A reader writes: "I just found and read the article pointing to oil futures showing 12/05 delivery as the justification for pooh-poohing a procnastication that oil prices will be at $80 by end of 2006. Today is 4/24/06 and last friday 4/21 futures for June delivery topped $75. $80 looks a little light right now. and the use of 12/05 contracts seems a bit short sighted."

The article in question is Can We Expect $100 Barrels of Oil in 2006? was published on August 18th, 2005. The reader is correct in pointing out that my doubts about continually rising oil prices proved to be incorrect. Here's a sample from the original piece:

Open any newspaper and you'll see at least one story about crude oil prices, usually discussing how high they are now and how much higher they are likely to be in the future. Most articles, such as this one in the Chicago Sun-Times include a graf detailing the predictions of a pundit such as:

Smith -- who last year predicted $3-a-gallon gas and $65-a-barrel crude oil prices this year -- says oil prices will jump to $80 a gallon by the end of 2006.

These predictions see, perfectly reasonable when you consider that the price of crude oil has more than doubled since the start of the decade, with most of that increase occuring in the last 12 months. Because of that, it would not seem unreasonable to predict that the price of oil will double once again in the next two or three years, as some pundits have.

Today the price of a barrel of crude oil is hovering around the $72 mark and the futures contract for December 2006 is at $75.80 - that same contract was selling for $63.88 when the first article was written less than a year ago.

Theory would suggest that futures contracts should provide a reasonably good estimate of what we should expect to see happen in the future. We should, however, be willing to alter or discard any theory which does not fit the data, if the data is conclusive enough.

Almost every pundit seems to be claiming that oil will keep going up and up in value. If this is the case, then why is it not showing up in oil futures? It seems to me you could make easy money by buying a December 2006 future now and selling it after a few months and collect a great deal of profit. Had you bought the December 2006 contract 8 months ago and sold it today, you would have made close to a 19% return, which is rather exceptional.

If it's such a certainty that oil prices are going to go up, why aren't people doing this? Why are all these free profits being left on the table? My answer is still that there is no "free lunch" - there's a very good chance oil prices are going to plummet in the near future, and hard, so the futures price is reflecting this. You may have a better explanation, though, and I'd love to hear it. You can contact me by using the feedback form.