A couple of weeks ago I published the article Why are Oil Futures so Undervalued? and I figured I'd hear all kinds of things in response. I managed to get all of 3 e-mails in response. I typically get more than 103! Plus none of the responses could figure out why oil futures are not predicting oil prices to rise, despite all the talking heads on TV saying otherwise.
I'm still trying to figure out this paradox. I've come up with four possible explanations, but I don't think any of them are very strong. I'd love to hear your thoughts. Here are the four possibilities:
- Nobody truly believes oil prices will continue to rise. That is, nobody in the know. The talking heads on TV whose job it is to alarm us about everything probably believe it. I know drivers who have been frustrated by past price hikes probably believe it as well. It's quite possible, however, that traders do not see this as being a likely possibility.
- Prices will likely rise, but there's a small chance they'll plummet. If there's a 90% chance that prices will rise $5 over the next 6 months, but a 10% sure they'll drop $45, then relatively flat oil futures makes sense. I can't see that being the case here, though - why isn't there an equal or even greater chance that oil prices will spike in price? Particularly since so many people believe that we're soon going to run out of oil.
- There's a risk of the contracts not being honored. I have no idea how likely this is, but it's an idea that a bond trader discussed with me. If it's possible that some supply shock would cause these futures contracts not to be honoured, then there's some risk in holding them. Thus they are not particularly valuable assets to be holding, particularly if prices are going to continue to rise as the oil supply shrinks.
- Prices really are going to rise and everyone is missing a golden opportunity. I don't believe investors are going to turn away that kind of free money, but I guess it's certainly possible.
