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Thursday, June 19, 2008

Do Oil Futures Impact the Cash Price? YES!!!

While I completely buy into the whole China / emerging markets story for a portion of the higher prices we've seen in oil, it is amazing to me how many people question whether new investors / speculators "inspectors" have made an impact. 'If it were "inspectors" where is the build up in inventory?' they asked. I believe much of this was was correctly explained by Paul's own readers. With the emergence of this little tidbit, which supports the hypothesis that not all information regarding the questionable (lack of) inventory build up is available, lets put that to rest until we get some better data points.

I thought I'd move on to discuss another reason listed as to why "inspectors" do not have an impact, which is because they:

"Invest in futures, rather than in physical supplies of oil. So every month, they must trade contracts that are about to fall due for ones that will not mature for several months. That makes them big sellers of oil for prompt delivery."
This is flat out flawed. In a nutshell, participants (buyers and sellers) of futures which CAN be delivered, can buy / sell the spot / future (or a mix of the two) because they are THE SAME THING, just with a different delivery dates. Think of a spot sale as a future at Time = 0. With more buyers emerging to invest / speculate, demand has increased which equals higher prices.

Let me provide a very basic example. For simplicity assume no financing or storage costs associated with the futures, thus the futures prices should always be equal to the spot (or else there is an arbitrage opportunity) and that only two dates of which the futures are available; 1 and 2 years out...

1) With no speculators; spot price = futures price at Time 1 and 2
2) Speculators (or index investors) new to the market buy at Time 2, driving up prices
3) The difference between 1 and 2 year prices are arb'd out by futures participants (ignoring cash market for now)
4/5) The spot market converges as those who typically buy in the futures market have an incentive to buy in the spot (i.e. producers or even hedge funds), while sellers who typically sell in the spot market, have an incentive to sell in the futures market and keep storing the underlying (either in inventories or in the ground).

Click picture for larger size

Thus, the actual position where futures players "invest" (Time 1 or Time 2) does not matter. What matters is the "net exposure" of their investments. Thus, rolling the position (the trading of contracts quoted above) which consists of a buy and a sell order to keep the investment in the futures market, has little or no impact on the spot price, as the "net exposure" does not change!

It is only at initiation of the new position that the demand for the underlying commodity has increased. As each day passes, more and more "investors" globally are adding commodities to their portfolios (because commodities are exploding) which increases the "net exposure", the net demand, and the price even more! Sound similar?