Contango Lessons

In an influential article, Litzenberger and Rabinowitz (1995) noted that 80-90% of the time the oil forward curve is in backwardation, ie future prices are often observed to be below the spot prices. They provide an explanation of backwardation using the analogy that ownership of oil reserves can be seen as holding a call option. If discounted futures prices are higher than spot prices and if extraction costs grow by no more than the interest rate, then all producers have the incentive to defer production and leave the oil in the ground. This gives the producers the option of leaving oil there rather than extracting it and incurring high storage costs, risks of sabotage, and so on. But if every oil producer waits, then there will be a shortage of oil today causing the price to rise. The net result is backwardation in which the oil price rises today to offset the advantage of waiting to see the price before oil extraction. Thus, according to this explanation, weak backwardation is a necessary condition for current production.

However, one striking feature in the current market has been the prolonged contango in the WTI forward curve. Figure 1 shows that during the last 18 months or so, the nearby (delivery) futures contracts have been trading at a discount to the second month futures contract. Figure 2 which plot the WTI forward price curve shows a very steep slope with the nearby contract trading at a discount of almost $9 to the December 2008 contract. So what can explain the current term structure?

Various explanations have been put forward to explain the current contango in crude oil markets. Advocates of the peak oil hypothesis consider that the current transition from backwardation to contango is due to a greater acceptance by market participants of peak oil. Simplifying greatly, peak oil theory predicts that oil production will reach a peak some time in the very new future after which production would start to decline. In face of an expected growth in global demand, this implies that oil prices for future delivery should rise faster than prompt prices. This would imply a contango structure with the contango widening at the later segments of the forward curve as impending shortages become more acute ahead in the future. However, this implication is not supported by the data: the term structure of futures contracts for long term maturities is in backwardation and the volume of outstanding contracts is relatively low which indicates that investors place little weight on peak oil predictions. After all, if market participants adhere to the view of peak oil, then they would have the opportunity to make large profits by buying the longest maturity crude oil futures contract that the market allows.

MEES