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.
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, 2005Delivery 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
- 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?
- 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.
- 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.
- 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.
- The pundits are wrong
- The markets are wrong and investors are leaving a lot of money on the table by not buying up crude oil futures
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