As a long-time oil economics researcher, I have spent more than a quarter century doing research on oil markets. Most of my research considered the spot prices in relationship with other financial and macroeconomic variables. Other researchers insist on working with futures markets because they argue that futures prices are forward looking and thus are a precursor of spot prices.
Most of the time, those prices diverge depending on how they process fundamental and transitory factors. When there is an oil glut in the market, market participants see the spot prices are going down without taking the futures with them. In this case, the oil market is characterized by contango, thereby the futures are above the spot. In other times, when a shortage is perceived to exist in the market, the spot is usually above the futures at contact maturity. The futures or forward curve would typically be downward sloping (that is, inverted), meaning as the contract goes further in maturity longer futures prices fall more. In this case, the market is characterized by (normal) backwardation.
This characterization of the movement in oil prices is relevant to what’s currently happening in oil prices. In the period from June 2014-January 2015, the benchmark oil prices (both Brent and WTI) plunged by about 60 percent, reaching about $46 for WTI and $46 for Brent. Of course, the drop has been exaggerated by the working of pessimistic oil speculators, OPEC’s change in policy and the prospective of a lifting of Iran’s economic sanctions. Those speculators then were bidding on an oil market that is well supplied and awash to the brim by oil, equivalent to a global oil surplus that exceeds 1.5 million barrels a day. Starting January 2015 and until now, the same oil prices have regained 40 percent of its June 2014 value. The rebound this time has been manipulated by optimistic speculators who have inflated the ongoing modest growth in oil demand and considered it as an antecedent of a drastic price rebound. Those speculators may have also exaggerated the implications of a perceived topping in the U.S. shale production.
The oil market had played this dancing game before, starting in 2008. In August of that year, futures prices started to slide down swiftly, plunging from $145.44 a barrel on August 14, 2008 down to $32 barrel by the end of December 2008. After the down game ended, the bouncing game started in early 2009 and oil prices had accelerated to well above $100 in October 2014.
Regardless of what the speculators are doing now and then, the futures and physical oil markets do not always see eye to eye particularly in the short run. The futures market sees a growth in the oil demand and is moving futures prices up, while the spot or physical market perceives a mounting supply and is sending its prices below futures prices. This means currently we have again a contango in the oil market.
It will be remiss if I do not cite similar conditions centering on June 2014. The physical market foresaw weakness in spot prices but the futures market prophesied strength going forward. However, in October 2014, the futures price started a new drastic drop, which ended in January 2015, shaving off about 60 percent of its value. Since then, the futures price bounced back and restored 40 percent of its June 2014 level.
Which market should we believe? Under short run abnormal conditions such as the current one, the futures market is myopic and is very vulnerable to the actions of zealous speculators. If this is the case now, then the futures market is not sending us the correct signals about expected future oil and gasoline spot prices, thereby another drop in the oil prices is not far off and more fluctuations are still in offing supported by the adaptability of efficient oil shale producers to switch production on and off as the price reaches a certain level. High quality oil is now being pumped in several oil-producing countries (i.e., Norway, Azerbaijan. Iraq, Venezuela and others) and is loaded on tankers but they have no buyers in sight. A large amount of Iranian oil is highly likely to come to the market if the oil sanctions are lifted. The conflict in Yemen, which may have added about $10 a barrel to the risk premium component of the oil price, may have outlived its usefulness. Added to those factors the expected new rise in the U.S. dollar which has a dampening effect on oil prices.
This could be another future opportunity to invest in oil stocks when the prices are on the second leg down. Still, caution is warranted as we await a repeated game since the oil market has become crazy.