by Matt Roma
Crude oil futures prices didn’t leap higher after a federal judge recently ruled to overturn a six-month ban on new deepwater drilling in the Gulf of Mexico. That may seem puzzling to many investors. While there are certainly many more factors at play, the drilling ruling should cause downward, not upward, pressure on prices. Any new drilling wouldn’t produce any new oil for many years.
It’s important to know how the price of crude oil is determined in the futures markets. As a simplified example, futures parity is explained as follows: Future Price = Spot Price x (1 + Costs – Benefits).
In even simpler terms, where there are no carrying costs or benefits to holding the physical oil product, the difference between the crude oil futures price and the spot price of crude oil would be only explained by the cost of borrowing money to buy in the spot market, and hold until the expiration of the futures contract. The price of a futures contract should not take into account any expectations of future price movements.
In reality, another factor determining future oil prices is the cost of storage. While this cost can be quite high, if the spread between the spot price and the futures price (in contango) becomes too wide, than theoretically, there is an arbitrage opportunity.
For example, imagine a spot price for oil trading at $100/barrel, a one-yr futures contract trading at $115/barrel, interest rates of 1 percent, and a storage cost of $1 per month. A speculator could borrow $112 today, buy a barrel of oil, and enter a short one-year futures contract at $115. The $112 borrowed would pay for the barrel of oil and 12 months of storage costs. Then, one year from now, that individual would sell the barrel of oil at $115, repay the loan of $113.12 (112 x 1.01) and net a risk-free profit of $1.88. All while putting up no money.
To eliminate this type of opportunity, the spot price of oil would be bid up and the futures price would be sold down to levels where there is no longer an arbitrage opportunity.
When drilling is allowed to resume in the Gulf, the expectation of future oil supplies will increase, and the market price will immediately adjust to those future expectations. All else remaining equal (no change to demand expectations), higher expected supply will drive the price of oil futures down. (Higher supply in three years = three-year futures moving lower) If carrying costs and interest rates are equal, if the price of crude oil futures move lower, than the spot price must move lower as well to eliminate any possible arbitrage.
Since storage costs are going to fluctuate based on supply and demand, higher expected future supplies will result in lower storage space available, meaning higher storage costs. All else remaining equal, the increased storage costs would give a higher cost-to-carry for oil, thus driving the current price down to satisfy the spot/futures parity.
Therefore, any announcement that affects future supply or demand, even several years away, will cause price fluctuations in the spot price and near term futures as well.
I have only covered just a few of the concepts relating to options here. I encourage you to explore the topic further. Please feel free to call me with any questions you have about options, and the types of strategies that might be suitable for your unique situation.
Matt Roma is a Senior Market Strategist. He can be reached at 866-231-7811 or via email at mroma@lind-waldock.com.
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