Oil, war, and market expectations

As an economist, I’ve had a 40-year involvement with commodity futures contracts. I particularly appreciate the hedging function that these instruments provide. The classic example is the farmer who can sell wheat futures contracts to lock in the sales price for his produce in the expected month when the crops are harvested. Baking companies could use those same contracts to lock in the price of their prospective wheat purchases, with an analogous scheduled horizon.

An essential component of futures markets is speculators, who allow hedgers to transact when they need to, without necessarily having a contemporaneous hedger on the other side. Those speculators provide the liquidity to allow the risk transfer that the hedgers are seeking to be fulfilled.

In the first example, when the farmer sells the wheat futures, the counterparty to this trade (i.e., the buyer of the wheat contract) would generally be a speculator. The speculator’s purchase of the futures contract would reflect a bet that wheat prices would rise prior to the contract’s expiration. In the second example, the baker buys the futures contract, and the counterparty to the trade would be the seller, in this case betting that wheat prices would fall.

To be clear, the futures hedger’s objective is to lock in the price for a projected purchase or sale, thereby eliminating the preexisting price risk inherent in the underlying economic activity. In contrast, speculators are those willing to bear the risk that the hedgers are looking to avoid. Speculators’ bets pay off when their market forecasts are correct. If they’re right, they win; if they’re wrong, they lose.

That hedging orientation applies to myriad situations beyond agricultural products, including energy markets, metals, currencies, and a host of securities, including those relating to fixed-income securities and equities.

In many cases, futures contracts reflect consensus views as to where prices are likely to be over time horizons that extend through the futures’ expiration listings. Given what’s going on in Iran and the Strait of Hormuz, I was curious to see what the futures market for crude oil was predicting about where these prices were likely to be over the coming year. The most actively traded futures contract for crude oil is the West Texas Intermediate (WTI) Light Sweet Crude Oil futures contract. While this contract lists monthly expirations for the current year and the next 10 calendar years and two additional contract months, the trading volume is concentrated in the contracts closest to expiration, with volume often sporadic in the most distant expirations.

In any case, with little indication that the Iranians will open the Strait of Hormuz any time soon, it seems reasonable to expect oil to be elevated for some time. But for how long? If futures prices are to be believed, we’re looking at a peak in oil prices as soon as next month, with prices subsequently falling from there. A year from now, these prices suggest that crude oil may well be on the order of 25 percent cheaper than it is today.

Whether as a hedger or a speculator, I’ve always been attracted to the idea of buying more distant futures contracts when they’re cheaper than those closer to expiration, and vice versa, thinking that those price disparities give an edge to one side or the other. In this instance, with the price of more distant futures cheaper than the price of the contract closest to expiration, that would translate to an advantage for the hedger who needs to buy crude oil in June or later, as it allows this hedger to lock in at a cheaper price than the market allows today. For the speculator, this price configuration would translate to betting (hoping) that the more distant futures price would go up. That’s something I just can’t quite do. Even if it does seem to be a reasonable bet, it’s not something I’d be terribly comfortable cheering for.