GAUGING OIL PRICE DIRECTION FROM ITS FUTURES PRICE

No one can predict the oil price 1 month ahead, next week or even tomorrow. But still, some businesses e.g. Airlines have to try because they have to hedge their fuel cost against swings in their fuel cost. In economic planning, governments also need to forecast revenue and expenditure.  One of the ways to hedge is by buying a Futures contract [which is the promise to deliver something at a certain price at a certain time in the future]. Such as the Brent Oil Crude Futures of the CME Group (former Chicago Mercantile Exchange) in the chart above.

Can the 1-year, 2 year and 5-year Futures price of oil give us an indication of the direction of oil price? We know that prices change according to events that happen every day and every hour; and no one can predict such events from Libya oil terminals burning to release of data on China’s economic growth.

There are two reasons why the Futures price can be a predictor of prices in the future: (1) The futures price is determined by thousands of market players each having their own view, and after all the bids and offers, the final price is a median price of what is expected. It is generally true that the outcome of a prediction will be closer to the median of the prediction, and the larger the population of predictors, the more this will be true. (2) Prices change as events unfold. This fits in with Bayesian theory of conditional probability where the probability of an event happening (pX) is conditional on other events happening (pY1….pYn), and the pX is continuously revised as pY1…pYn changes. This is probably the most realistic way to forecast. And it’s what we see when we read the news and economists and governments keep on revising their forecast of GDP growth, industrial production etc. * Everyone should read Nate Silver’s book “The Signal and the Noise”. He has been most successful in making forecasts of outcome of sporting events (baseball) and political elections at his well-known Blog www.fivethirtyeight.com

SO WILL OIL PRICES KEEP ON DROPPING?

In the chart above, we see the cash price of Brent oil and the prices of Brent Oil Futures for 1 year ahead, 2 years ahead and 5 years ahead. This is over a 4-month period and if you go to www.barchart.com you can see all these prices changing every few seconds. The financial markets never sleep.  So what can we see from the chart above?

a.      Currently cash as well as all three Futures prices have bounced from their lowest point.

b.      1 yr, 2 yr, and 5 yr futures prices are ALL higher than cash price of 60.64 [1yr: 67.16; 2yr:72.43; 3yr:78.60] That’s a cause for optimism.

c.      The biggest difference from cash price is the 5 yr Futures. And the difference gets smaller with 2yr and 1 yr Futures. This adds to the optimism since usually the longer into the future the greater the uncertainty and risk.

d.      Another reason for optimism is that even for the 1yr Future, the difference from the cash price is 10.7% That is more than the 7.8% between 2yr and 1 yr and 8.5% between 5 yr and 2 yr. So most market players seem to think that the current decline won’t last long.

Other analogical evidence that we have probably seen the worst of oil price decline?

1.      Saudi Arabia is planning its annual budget based on $80.00 per barrel

2.      China has been chartering lots of supertankers (VLCC Very Large Crude Carriers) to buy crude from the Middle East and other countries to add to its strategic oil stockpile.