By Arnold Kling
As of May 20th, the June 2004 futures contract for light crude oil was at $41.66, while the June 2005 futures contract was at $35.58. When futures prices are below spot prices, this is known as “backwardation.” I believe that it represents a puzzle. Think of it this way. If you have oil, by holding onto it for a year, you are losing 15 percent. That seems kinda dumb.
One argument for a long-term drop in oil prices is that human ingenuity progressively reduces the value of natural resources. However, as Tyler Cowen points out in response to a previous post of mine, anticipated changes in the value of resources should be priced into the market today. If you expect human ingenuity to lower the value of oil in ten years, then that reduces the value of oil right now.
See also Russ Roberts, who correctly factors in expected reductions in extraction costs, although I don’t see those falling at 15 percent per year.
Another argument is that when backwardation occurs, inventories drop to near zero, because oil refiners are not stupid–they sell everything they have. Then, because inventories are so low, spot prices go up. Thus, you get a vicious cycle, as argued here.
In 1996, the price volatility was on the upside when tight stocks and the expectation of Iraqi exports encouraged severe backwardation in the crude oil futures markets. The backwardation, by discounting the value of crude oil in the future, discouraged stock building. This kept [near-term] crude oil prices high.
Still, this “backwardation vortex” requires the owners of oil to hold it off the market in order to sell it for a lower price later. Owners would include the Saudis as well as the U.S. Strategic Petroleum reserve.
In addition, the theory that it is thin inventories that cause a near-term price spike would suggest that the U.S. could get considerable leverage out of a sale of oil reserves. Even though our oil sales might be small relative to oil flows, they could be significant relative to oil inventories, which are near zero.
Finally, I was going to argue that instead of a physical reserve of oil, the government (or individuals) could hedge against an oil shortage by purchasing oil futures and options contracts. However, this point was made already by John McCormack, almost ten years ago.
What fixed prices could one lock in today? I conducted an informal survey of swap dealers on November 27, 1995 that indicates prices of about $17.75 for the period 1996-2000 and $18.80 for the period 1996-2005.
This is at a time when spot crude is $18.38. In other words, for many years into the future one can guarantee oneself crude oil prices that are lower than current prices.
For Discussion. Speculators buy low and sell high. The American and Saudi governments do the reverse. Which is the stabilizing force in the oil market?