Can We Expect $100 Barrels of Oil in 2006? - Oil Futures Say No

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.

If these predictions are true, and given our experiences this decade they seem perfectably reasonable, then why are these expectations not being reflected in futures markets?

Futures contracts for light, sweet crude oil are traded on the New York Mercantile Exchange. An oil future, like any commodity future "is a contract to buy or sell certain certain goods, such as oil, at set prices at a predetermined time in the future". These are not just bought and sold by those interested in actual physical barrels of oil - crude oil futures are purchased by investors and speculators as well. In fact, "about 95% of oil traded on the Nymex never shows up as physical product" (Source PDF). Because of this, we should expect that the price of a crude oil future should be a rough guide to the future price of oil.

The Price of Crude Futures as of August 18th, 2005

Delivery Date - Price

Sep '05 - $63.25
Oct '05 - $63.85
Dec '05 - $64.88
Sep '06 - $64.42
Dec '06 - $63.88
Dec '07 - $61.39
Dec '08 - $59.74
Dec '09 - $58.64
Dec '10 - $57.94
Dec '11 - $57.64

As you can see, oil futures do not predict $80 barrels of oil in 2006. They seem to predict that oil prices will rise, but only by a dollar or two. Why the discrepancy? I can think of a few reasons why futures contracts may be lower than predicted oil prices, such as:

1. The time value of money: By buying a futures contract, you're tying up money today for a good to be delivered months or years from now. If I wanted oil in September 2006 I could either buy a future contract today, or take the money, invest it in a stock or bond, then sell that asset in 2006 to pay for the oil I need. Futures prices tend to reflect this, which is why the future price for oil in 2011 is so low. But can the time value of money really be so high that people are willing to pay $80 for a barrel of oil next year when they can "lock in" at $64.42 right now?

2. Liquidity: Futures contracts for far off dates such as December 2011 tend to be very illiquid - there are not too many buyers or sellers. That is not the case for contracts in 2006, as they are traded multiple times a day.

3. Future Prices as a Mean: Perhaps many people believe that a barrel of oil will be $80 or $100 next year and are buying contracts based on that belief. If there are investors who believe that oil prices will crash and expect $30 barrels next year, then they would be acting to drive the futures price down to the current level. To get a better idea if this is happening, we would need to consider the price of crude oil options, not just futures.

4. Entry Costs: The minimum crude oil contract that one can buy or sell on the NYMEX is in the range of $33,000. This may deter many investors from entering the market, leaving the price artifically low.

Can these factors be causing the price of crude oil futures to be artificially low? It wouldn't seem so given the magnitude of the spread between futures prices and pundit expectations. So either:

1. The pundits are wrong

2. The markets are wrong and investors are leaving a lot of money on the table by not buying up crude oil futures

I'm not sure which to believe. The second explanation seems pretty unlikely, but then again, crude oil futures did not anticipate the recent rise in price. My gut still tells me that the first explanation is the correct one, but I'm not as confident in it as I would like to be.

I'd love to hear what you think on the matter. You can contact me by using the feedback form.