Where was I? Ah yes, why would someone want to place an order for oil to be delivered months or years from now?
Well the answer will help define the futures market.
Lets say I place an order, 1000 barrels of oil to be delivered in November at a price of $130/barrel. Realize that Im a trader and I have no intention of actually taking delivery of that oil. My motivation is the hope (based on some sound research hopefully!) that the actual price between now and that date will increase. So before I actually take delivery I can sell my contract to someone else. If the price rises to $140/barrel then I get to make $10,000, or a roughly 7% return on my investment, that would be a decent return for 5 months.
That would be called a "long" trade. Buying oil hoping the price will rise, so I can sell it later and make a profit.
There is however another way to do business.
I can sell someone oil that I do not have. This may seem to be the riskier move but its really no different. By selling oil I do not have today, I commit myself to buy some later. By making a contract now at todays price, I hope that the price later will be lower - the difference being profit
This is called selling "short".
It should be apparent that there are plenty of people who do need to buy oil, they need oil to refine it. But the key element is that there are lots of traders selling short, to other traders who are betting long. If more folks bet long then todays price must rise. In addition to todays price changing you can also look at the prices being charged for contracts way out into the future.
Various trading sites, and the NYMEX.com site will let you take a look at prices far out into the future like that.
Its possible to look at those future contracts and draw some conclusions about what traders think the market will do.
Thanks to Jeff Vail of theoildrum.com we have a chart that can let us see what I mean
Jeff made this chart on the 20th of May 2008 and it shows how the prices for future delivery (months out in the future on the X axis) vary compared with the front month price. The typical price structure is known as backwardation. This would involve distance future prices being lower than todays front month (earliest possible delivery point) price.
That should strike you as normal, because the alternative known as Contango leaves open some intersting possibilities. If you could see prices for distant contracts raising much higher figures than todays prices you would have contango. You could buy some oil at the front month price and sell some oil at the higher future price, then take delivery of the cheap "today" oil and store it for when youre future contracts delivery date comes up. Although we know the cost of storage would never be zero, we can still see why this situation would not be considered all that normal, it would lead to folks hoarding oil.
If the future price gets high enough (which means traders have decided that through the buying and selling of contracts) then hoarding is exactly what will happen. If futures prices get high enough (high enough to offset the cost of storage and inflation) then you could make money by simply storing oil. Its unlikley that the market can get that hot, the front month price will rise too fast, as traders start buying short term contracts to cover their long commitments.
Since Jeff made that chart the amount of Contango has settled back a little to mid May levels. But the point Jeff makes is that up until Mid April the market was still selling long term future contracts at LESS than the front month price (in backwardation). The fact that it is now higher is only significant from a purely theoretical perspective. With the costs of storing oil, and inflation taken into account you still couldnt make any money by simply hoarding oil.
But its a useful way of looking at the market to determin if its "hot" or not.
You wont see this kind of analysis in the media, I think because its too simplistic for the traders, and too complex for the average joe on the street. Hopefully you found it thrilling...
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