Behavior of Oil Price Curves

Behavior of Oil Price Curves

Contango markets are economically limited by full carry. Any price level above this limit would introduce an arbitrage opportunity. If the forward price exceeds the spot price by more than full carry, an arbitrageur could buy the spot commodity, store it, and sell it forward at the futures price for a riskless profit. Because a contango market cannot steepen to arbitrarily high levels, the risk of a long basis position (long cash and short futures) is limited. In general, the closer the market is to full carry, the less risky the position.

Energy markets shift between contango and backwardation, often with little or no warning. The term structure of crude oil given by the NYMEX futures prices for a six-month period in mid-1994 is depicted in Exhibit 5. (Contract months are listed on the X axis.)

Exhibit 5

Mar 94 Crude

Apr 94 Crude

May 94 Crude

$16.80

ipr.94 Aug.94 Dec.94 Apr.95 Aug.95 Jun.96

lay.94 Sep.94 Jan.95 May.95 Sep.95 Jun.96

Jul.94 Nov.94 Mar.95 Jul.95 Nov.95 Dec.E

June 94 Crude

July 94 Crude

Aug 94 Crude

$18.00

$18.00

.ep.94 Jan.95 May.95 Sep.95 Jan.96 Dec.96

Jul.94 Nov.94 Mar.95 Jul.95 Nov.95 Dec.96

Aug.94 Dec.94 Apr.95 Aug.95 Dec.95 Dec.96

 

During the second quarter of 1994, the market shifted from a positive carry market (contango) to an inverted (backwardated) market. The backwardation was precipitated by strong economic growth and concerns over a supply disruption from producers including Nigeria. The oil market remained inverted only until August 1994. While oil markets can remain in contango or backwardation for protracted periods, this isn't always the case. Studies have shown that strings of either structure are almost impossible to predict.²²

The term structure of natural gas prices can be greatly affected by seasonal factors. During winter months, when demand for natural gas is high, markets may have a tendency to backwardate. During warm weather months, gas demand usually decreases. Holding all other factors constant, however, the market generally tends towards contango. The term structure of natural gas futures prices for six months in mid-1995 is shown in Exhibit 6. (Again, contract months are listed on the X axis.)

Exhibit 6

lun.95 Sep.95 Dec.95 Mar.96 Jun.96 Sep.96

lay.95Aug.95 Nov.95 Feb.96 May.96Aug.96

Apr 1995 NG

May 1995 NG

Jun1995 NG

Jul.95 Oct.95 Jan.96 Apr.96 Jul.96 Oct.96

Jul1995NG

Aug1995NG

Sep1995NG

$2.20

$2.20

$2.00

ig 95 Dec.95 Apr.96 Aug.96 Dec.96 Jun.98

$1.4C

.ep.95 Jan.96 May.96 Sep.96 Jan.97 Dec.97

$1.6C

ict.95 Feb.96 Jun.96 Oct.96 Feb.97 Dec.97

The curves show that the natural gas futures prices were in contango up to approximately the December futures contract, while prices for later contract months were backwardated. While the 1995 data suggest a clear pattern, it is very common for seasonal patterns to be overshadowed by other market factors.

Shocks to supply, unexpected weather patterns, or market structure influences significantly affect the term structure of energy prices. Changes in the balance of supply and demand are quickly reflected in the price level and term structure. However, despite strong price fluctuations and swings between contango and backwardation, the price of oil today (in constant terms) is at roughly the same level that it was 20 years and 100 years previous.²³

This price behavior has suggested to some in the industry that the term structure of oil prices can be described by two factors. The first factor reflects uncertainty about the short term price movements. Because demand for oil is relatively inelastic and immediate supply is constrained in the short term, the short term price is a function of the physical supply situation.. The second factor reflects uncertainty about a long term equilibrium price. Because cur­rent oil prices are at levels previously observed in history, some suggest that oil prices are mean reverting to a long term equilibrium price. This behavior suggests a second source of uncertainty with respect to the long term equilibrium price of oil. Among others, Dragana Pilipovi´c of Sava Risk Management Corporation, has developed a two factor model for the forward price curve. It is based on a spot price factor and a long term price factor. The two factors are linked through a mean reverting process.