Oil Markets: Don’t Mistake Short-Term Changes In Futures And Options Prices For Long-Term Changes

By Ed Hirs, Energy Economist

The global market for crude oil is roughly 34 billion barrels per year, or about 93 million barrels per day. Journalists ponder and report every flicker on the screens of oil traders, akin to the play-by-play analysts for sporting events.

In a recent article, Reuters’ senior market analyst John Kemp points to a very large increase in net long positions by “hedge funds,” raising fears that hedge funds are pushing up prices too soon and setting up the market for a quick fall.

Kemp further states that Hedge funds and other money managers held futures and options contracts equivalent to 791 million barrels of crude betting on a further rise in prices and just 128 million barrels gambling on a fall.”

But he oversimplifies.

Traders in crude oil futures and options contracts fall into two broad categories: oil companies or “market participants” on the one hand, and all others, “financial participants,” on the other.

For one thing, not all financial participants are hedge funds, because many other players fall into the financial participant category, including airlines, trucking and shipping companies, utilities and industrial users of petroleum products.

Second, financial participants aren’t necessarily “gambling” but doing just the opposite. Many are simply hedging against future price movements in order to bring some certainty to an aspect of their overall business.

Finally, there is the implication that the total long position by financial participants is a significant number relative to the size of the overall market. It is anything but; 800 million barrels – roughly the amount Kemp notes as subject to options and futures contracts betting on higher prices – represents less than 10 days of worldwide consumption, and the oil futures and options markets have contracts that extend for more than seven years. That 800 million barrels is less than 2.4 percent of the annual global market and less than 0.35 percent, just thousandths of the expected consumption over seven years.

The key point is this: the small size of the options and futures markets relative to the overall size of the market is what makes the options and futures markets so volatile.

Academic research indicates that the Brent and WTI forward price curves are poor predictors of future prices — very much like the forward prices in foreign exchange markets or agricultural commodities markets are poor predictors of prices realized in the future. The dynamics of the oil markets are played out day-to-day at the wellhead and refinery gate for producers, and at the pump for retail consumers. The volatile oil commodities markets provide some indication of prices in the very near term — days and weeks — but less so for months-ahead prices and hardly any guidance for years-ahead prices.

The real usefulness of the oil commodities markets is to provide a very small group of risk-averse consumers and producers the ability to lock in prices and assure level costs and profits at least until it is time for the annual bonus review. Those who mistakenly think that they indicate anything more are simply off the mark.

Ed Hirs teaches energy economics in the University of Houston’s College of Liberal Arts and Social Sciences. In addition, Hirs is managing director for Hillhouse Resources, LLC, an independent exploration and production company. He founded and co-chairs an annual energy conference at Yale University.

UH Energy is the University of Houston’s hub for energy education, research and technology incubation, working to shape the energy future and forge new business approaches in the energy industry.

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