I realise that the graph is a few days old – but you get the basic idea. Since June last year, the oil price has been swan-diving.
And if you were to google “Why has the oil price been falling?”, you’ll get these sorts of answers:
- There’s a supply glut.
- Demand for oil has been tapering off thanks to the global slowdown and the China slowdown (as though China is not part of the globe).
- OPEC didn’t cut production in November 2014.
- Everybody realised that the civil war in Libya, ISIS, and Iran oil sanctions weren’t such a big deal (!!).
- Better fuel efficiency in cars.
- Saudi is engaged in a price war to drive the US shale producers underwater.
This isn’t news.
As in – there is nothing new about this news. Maybe the bit about the OPEC decision on oil production – but the oil price started its decline in June 2014, not November 2014. The OPEC decision was surprising given the falling price of oil. To argue that it caused it is just nonsensical.
And as for the Libya/ISIS/Iran story, here’s another graph:
The oil price reacted to Iran, Libya and ISIS by being all “Whatevs, I’ll just be wiggling around my high here.”
Which is really to say: there are not many good answers out there, and this could just be a case of no one really knows what the oil price is doing .
But I wouldn’t be writing an entire post just to say that. I have a possible explanation that I want to throw out there. And any and all oil price buffs must feel free to disabuse me.
RollingAlpha.com’s take on the oil price drop
First off, a key fact about the oil price:
- The current oil price is not a pure function of the current demand and the current supply of oil (on the spot market).
- The current oil price is also a function of the past future expectations of the demand and supply of oil.
Does that sound like a philosophical thought experiment?
Let me try to clarify what I mean.
Oil producers (the supply) generally don’t just make a barrel of oil this morning, and then go and sell it on the market later this afternoon. The oil producers are locked into supply contracts through the oil futures market. Most of the barrels of oil that are extracted today were sold months ago on a futures exchange.
Which makes total sense – a lot of time and money is spent extracting oil from the ground. If you’re going to be doing that, you’ll want a guarantee of your selling price months ahead of time.
And the same thing goes for customers. Airlines, for example, need to price jet fuel into their tickets months ahead of time. They can’t do that unless they know how much their jet fuel will actually cost, so they buy the oil in advance on a futures exchange.
- Months before the oil is extracted and turned into jet fuel, the oil producer will sell a contract (for the delivery of oil in a few months’ time at an agreed price) on a futures exchange.
- The airline will buy the futures contract (thereby making the price “agreed”).
- When the futures contract “settles”, it does so on delivery day, when the airline receives its delivery of oil.
Obviously, this doesn’t cater for all the oil. Suppliers can sometimes extract more than they anticipate (or less than they anticipate). Customers can buy more fuel than they need (or less fuel than they need). Meaning that there is also a trade in oil that is extracted today and sold at the market this afternoon (maybe not quite this afternoon – but soonish).
In and between all this genuine oil demand and supply, you also get speculators. Speculators who are hoping to buy cheap oil for future delivery on the futures market, and then sell it when the price is high come delivery day on the spot market. Or vice versa. Or whatever else is going on with commodity traders.
Here’s where I’m going with this:
- I think that when oil supply was looking too good for OPEC not to cut production, and ISIS was kicking into gear, and the Iranian oil sanctions were picking up speed, speculators did not go out and play with real oil.
- Real oil is astonishingly expensive to store. It means that you have to find a tanker for it. And hire a crew to look after it. And other things that sound a lot like hassle.
- It’s much easier to buy a futures contract on oil.
- So rather do that.
- If I buy a barrel of oil today at $120, then I actually have to pay $120. But if I buy a futures contract for oil at a price of $120 per barrel, I don’t actually have to pay $120 until the futures contract settles. I just have to put down some money (“post margin”) with the exchange. Even if I have a 10% margin, that’ll only be $12 per barrel. And I’d be able to buy 10 barrels of oil forward for every barrel that I actually bought today.
I give you this graph:
What you want to look at is the shaded areas. And a “net long position” means the volume of future oil that had been bought by traders.
Here’s what I think happened here:
- With ISIS and Iran and so on, traders started buying up futures contracts (from about January 2014) betting on a steep rise in oil price on the back of ISIS and Iran, as well as a hope that the global recovery would gather steam in 2014 (meaning that oil demand would keep pace with the oil supply).
- Unfortunately, by June, some of the earlier futures contracts started expiring with speculators receiving calls from the exchange that went something like “To which shipping address may I direct your oil, sir?”
- To which most speculators replied “Just sell it in the spot market. I don’t want it. Bah humbug.”
- And then there was an avalanche of contract expirations, with no real demand for oil behind them.
- So all that oil needed to be sold in the spot market.
- Causing the real oversupply to suddenly hit the spot market.
The good news: the long contract positions are starting to tick back up (so perhaps that little bubble is over?).
The other indicators that the oil price could be recovering soon: the oil market is quite deeply in contango.
What is Contango?
There is obviously meant to be a fairly clean relationship between the spot oil price and the futures oil price. And it’s built on this premise:
- If I want to use a barrel of oil in three months time, I could:
- Borrow the money from the bank, buy the barrel of oil today, insure and store it, and then use it in 3 months’ time; or
- Buy a futures contract for oil with delivery in 3 months time.
- The futures price should always be a bit higher than the spot price, because it needs to compensate for all the costs that I’m saving by not buying and storing it today:
- interest on the bank loan
- storage costs
- insurance costs
When a futures price for a commodity is higher than the current spot price, traders talk about the market being in “contango”. So you’d normally expect slight contango due to all those costs associated with buying the product at spot and storing it.
But when the contango is quite extreme, it implies that there is a glut of oil supply today that is not expected to last too long, and you hear about oil traders hiring oil tankers and going through the hassle of putting their oil into storage.
Funnily enough, here is a Bloomberg article on the subject from a month ago. And here is a more recent piece.
I guess that if I’m close to right, then saying that the oil price is falling because of the supply glut is entirely accurate. It’s just that supply gluts have these curious impacts because the market is not distinct in time.
How’s that for a philosophical conclusion?
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.