Sunday, October 25, 2009

Tale of the Curves

In each of the past four years the spot oil market has traded around US$80 per barrel (see chart 1 below). Over that time, we have seen a high of US$147.27 and a low of US$32.40.

Chart 1: NYMEX WTI Crude Oil 1st Month Price (click chart to enlarge)
What is interesting is the change in the shape of the forward curve each time we have traded at or close to US$80 (see chart 2 below).

For example, December 2015 was US$69.07 on September 14, 2007 (point A in chart 2 ) and is currently US$93.95 (point B). In other words, the expected price of oil in December 2015 has risen by almost US$25 per barrel in the past 2 years.

Chart 2: NYMEX WTI Crude Oil Forward Curves (click chart to enlarge)
The back end of the oil curve has risen steadily due to three reasons: 1. the expected marginal cost of future supply has increased over the past two years; 2. the US dollar is expected to weaken in oil terms; and 3. an early 1980s-type efficiency drive is expected to make demand more resilient to higher prices than demand has been over the past twenty years.

As you may be aware, oil forward curves have historically not been a good predictor of future prices. Forward curves are a summation of current market expectations. Expectations change over time as new information becomes available.

I don't think that the current forward curve correctly reflects the most probable oil price scenario over the next ten years. However, humility in the face of market expectations and an understanding of those expectations is essential before one can disagree with them.

For an explanation of forward curves, look at Chpt. 18 of Oil 101.
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