[PenultimateManStanding]

An interesting article seen at LATOC today. The theory is that Ahmadinejad wants the high oil prices to save his Presidency and thus the bluster (pretty much in line with my own interpretation of the whole Iran thing: bluffs). But this paragraph left me baffled:

$this->bbcode_second_pass_quote('', 'L')ooking back say four years ago, before the tripling of assets under management by commodities hedge funds, many of these markets were in “backwardation”. That is to say, the price of oil, for example, in future months was lower than it was in the active, nearer month. And why not? After all, if the same oil could just as easily be left in a free storage facility called “the ground” rather than being pumped up and piped into a metal tank for which the owner would pay interest and storage fees, would this not put a lid on the amount of capital someone would want to commit to buying crude oil?

[PenultimateManStanding]

The unspoken assumption appears to be that if you buy "future oil" you have to pay for the storage. How does this work, you buy a future contract and so somebody pumps it and sets it aside for that future delivery date? It doesn't actually work like that does it? It would seem to be what this writer for the FT site is saying.

[rogerhb]

I thought that this is about whether a future price is cheaper or more expensive than a current price.

In theory, if you have a limited resource, it's price in the future should be more expensive as there will be less of it in the future.

Contango

It's about recognition of increasing scarcity.

[PenultimateManStanding]

$this->bbcode_second_pass_quote('rogerhb', 'I') thought that this is about whether a future price is cheaper or more expensive than a current price.

In theory, if you have a limited resource, it's price in the future should be more expensive as there will be less of it in the future.

Contango

It's about recognition of increasing scarcity.

[rogerhb]

$this->bbcode_second_pass_quote('PenultimateManStanding', 'B')ut I'm reluctant to even read your wikipedia article, financial writing has so traumatized my sense of understanding. I think that nobody really gets it, and we can all just sit back and watch the ball of confusion grow.

[PenultimateManStanding]

$this->bbcode_second_pass_quote('rogerhb', '')$this->bbcode_second_pass_quote('PenultimateManStanding', 'B')ut I'm reluctant to even read your wikipedia article, financial writing has so traumatized my sense of understanding. I think that nobody really gets it, and we can all just sit back and watch the ball of confusion grow.

[rogerhb]

$this->bbcode_second_pass_quote('PenultimateManStanding', 'O')K, there you go, the ball of confusion covers the land and nobody knows what the hell is going on. Should I explain better perhaps rog?

[PenultimateManStanding]

$this->bbcode_second_pass_quote('rogerhb', '.').. the ball of confusion......

[rogerhb]

The snowball of the confusion comes from flatearth economists who have seen future prices dropping for non renewable commodities and hence convinced themselves that these finite resources must in fact be infinite, else why would future prices drop?

Ipso facto, QED, the market cannot be wrong, etc....

[big_rc]

OK let's see if this example makes sense.

You are the owner of an operation that uses 10,000 barrels of oil per month to do business. When oil was cheap and plentiful, you would buy only 10,000 barrels once a month and keep available stocks at the lowest possible levels. (Remeber that it costs big money to build and maintain tank farms and hold expensive inventory and why invest the firm's valuable money in unnecessary capital when the price of oil is relatively stable. It's going to cost pretty much the same today as it will tomorrow.)

Now what happens when oil price begins to skyrocket (and you expect prices to go even higher). You quickly buy up all the oil your company can handle today and start building as much extra storage capacity as quickly as possible. Your actions are a direct example of why the oil markets are in contango right now. You see oil today as a "bargain" and are more than willing to pay the carrying/storage costs to protect your bottom line. So the markets are telling us that the "future" price of oil is expected to be higher than "today's" price because people are more than willing to buy as much as they can now and gladly pay the costs to hold on to it.

I hope this makes some sense.

[PenultimateManStanding]

So you say that people used to just buy it as they needed it, but now they store it? What about this from the article: "but they don’t seem to think the opportunity will last long enough to finish building the tanks and take the money. So they’re not doing it." Nobody's building tank farms it says here. How does this fit into the contango thing.

[smallpoxgirl]

It's really not that complex.

You're going to need gas for your car a year from now right? So you go down to Sam's club and they offer to let you pay today, and in return they'll give you a hundred gallons of gas next summer. How much are you willing to pay per gallon?

So are you an optimist or a pesimist? Optimist says, "There will be plenty of gas next summer. Might even be cheaper than now. I'll just buy it as I need it. I'd better be getting a steep discount to buy it a year in advance. I wouldn't pay more than $1.50 per gallon for it." That's backwardization. Commodity futures cost less than commodity for immediate delivery.

Pesimist says, "Wait a minute. Gas prices keep going up. I bet gas will be $10 a gallon by next summer. I'd be willing to pay at least $5 per gallon for it now so that I make sure I have some next summer. Even if I don't use it all, I bet I can sell it to my neighbor and make a profit. I could store it myself, but it'd be a lot simpler just to pick it up at Sam's Club next summer when I need it." That's contango. Futures cost more than commodity for immediate delivery.

So when the futures market goes contango, its a pessemistic sign. People are expecting prices to climb.

[big_rc]

$this->bbcode_second_pass_quote('PenultimateManStanding', 'S')o you say that people used to just buy it as they needed it, but now they store it? What about this from the article: "but they don’t seem to think the opportunity will last long enough to finish building the tanks and take the money. So they’re not doing it." Nobody's building tank farms it says here. How does this fit into the contango thing.

[rogerhb]

$this->bbcode_second_pass_quote('big_rc', 'T')hat is also why this whole contango thing is pretty neat because companies are willing to make this investment to store this stuff now because they see today's oil as cheap relative to future prices

[PenultimateManStanding]

$this->bbcode_second_pass_quote('big_rc', '')$this->bbcode_second_pass_quote('PenultimateManStanding', 'S')o you say that people used to just buy it as they needed it, but now they store it? What about this from the article: "but they don’t seem to think the opportunity will last long enough to finish building the tanks and take the money. So they’re not doing it." Nobody's building tank farms it says here. How does this fit into the contango thing.

[rogerhb]

$this->bbcode_second_pass_quote('PenultimateManStanding', 'N')ow what has me confused is how some supposedly new reluctance to invest in tank farms is shifting the balance from backwardation to contango.

[PenultimateManStanding]

$this->bbcode_second_pass_quote('rogerhb', '')$this->bbcode_second_pass_quote('PenultimateManStanding', 'N')ow what has me confused is how some supposedly new reluctance to invest in tank farms is shifting the balance from backwardation to contango.

[big_rc]

$this->bbcode_second_pass_quote('PenultimateManStanding', '')$this->bbcode_second_pass_quote('big_rc', '')$this->bbcode_second_pass_quote('PenultimateManStanding', 'S')o you say that people used to just buy it as they needed it, but now they store it? What about this from the article: "but they don’t seem to think the opportunity will last long enough to finish building the tanks and take the money. So they’re not doing it." Nobody's building tank farms it says here. How does this fit into the contango thing.

[rogerhb]

You mean because we have no above ground storage we are using it like it's going out of fashion, and if there was more storage we would not use so much of it because we would save some for the future.

Me thinks that would not happen if we did have the storage, because people want both the money and fuel now. As a species we are crap at looking after the future. If people started storing it away in these tanks in a meaningful way it would raise the price of fuel now, so they would stop putting it in the tanks.....

[PenultimateManStanding]

$this->bbcode_second_pass_quote('smallpoxgirl', 'I')t's really not that complex.

You're going to need gas for your car a year from now right? So you go down to Sam's club and they offer to let you pay today, and in return they'll give you a hundred gallons of gas next summer. How much are you willing to pay per gallon?

So are you an optimist or a pesimist? Optimist says, "There will be plenty of gas next summer. Might even be cheaper than now. I'll just buy it as I need it. I'd better be getting a steep discount to buy it a year in advance. I wouldn't pay more than $1.50 per gallon for it." That's backwardization. Commodity futures cost less than commodity for immediate delivery.

Pesimist says, "Wait a minute. Gas prices keep going up. I bet gas will be $10 a gallon by next summer. I'd be willing to pay at least $5 per gallon for it now so that I make sure I have some next summer. Even if I don't use it all, I bet I can sell it to my neighbor and make a profit. I could store it myself, but it'd be a lot simpler just to pick it up at Sam's Club next summer when I need it." That's contango. Futures cost more than commodity for immediate delivery.

So when the futures market goes contango, its a pessemistic sign. People are expecting prices to climb.