Money illusion and “real backwardation” in oil
Forward commodity prices are not properly accounting for the impact of inflation.
“Money illusion” was the term coined by Cambridge economist John Maynard Keynes to describe the tendency of people to be fooled by thinking in nominal rather than real terms, ignoring the effect of inflation on the purchasing power of money.
It is usually associated with unsophisticated retail investors. But there is evidence it is misleading a much wider group in the commodity markets, and long-term commodity prices are being mis-valued as a result.
While this is discouraging producers from selling their forward production, it is also creating a potential source of returns for long-term investors frustrated by the damage wrought by the contango nearby.
REAL FORWARD PRICES
Chart 1 shows the forward curve for light sweet crude oil futures on NYMEX at the close of business on May 14:
(1) http://graphics.thomsonreuters.com/ce/REAL-OIL1.pdf (2) http://graphics.thomsonreuters.com/ce/REAL-OIL2.pdf (3) http://graphics.thomsonreuters.com/ce/REAL-OIL3.pdf
In nominal terms, the curve is in contango (upward sloping) along its entire length. Prices rise from $72 for the Jun 2010 contract to $81 for Dec 2010, $86 for Dec 2013 and $90 for Dec 2015 .
But NYMEX prices are fixed in cash terms. They take no account of inflation. If inflation runs at an average of 3 percent per year, the $90 Dec 2015 contract will be worth only $77 (present value terms) when it matures in just over five years time.
Chart 1 shows the forward curve adjusted for a family of inflation rates (ranging from 1 percent to 5 percent per year).
In real terms, the curve is no longer in contango throughout its entire length. Real prices flip into backwardation sometime between April 2011 and January 2013, depending on the inflation rate chosen.
Only for average inflation of 1.75 percent or less for the next five years (which is exceptionally low) does the curve remain in contango along its entire length. For any rate above 1.75 percent, quoted forward prices do not rise fast enough to offset the impact of inflation (Chart 2) especially beyond Dec 2010 (Chart 3).
ARE FUTURES TOO CHEAP?
For inflation of more than 2 percent, averaged over five years, the market is offering investors the opportunity to buy forward crude futures for less than today’s spot oil price, in real terms. There are three possible explanations for this strange state of affairs:
(a) The market expects oil prices to fall in real terms over the next five years (because supply remains ample or demand is expected to fall as conservation and substitution bite into consumption). In this scenario, peak oil is a myth. Prices will actually drift lower (in real terms) as previous shortages dissipate.
(b) The market is assuming inflation will remain low (less than 1.75 percent over the next half-decade). The economy might even suffer deflation. Sluggish growth and surplus capacity will ensure prices rise slowly, even decline. In a low-growth, deflationary environment, demand for oil, and oil prices, are unlikely to rise much.
(c) The market is mis-valuing far forward contracts, marking them too low to fully reflect the compounded effect of rising prices over five years.
Neither explanation (a) (falling real oil prices) nor (b) (general deflation) seems consistent with expectations of a gradual global recovery and medium-term tightening of the oil market as demand picks up and new sources of supply prove difficult and costly to bring onstream. So explanation (c) (futures contracts are undervaluing expected future oil prices) is the most plausible.
RISK PREMIUMS DISAPPEAR AT FRONT END
The undervaluation of forward oil contracts (in real terms) is another form of “risk premium” investors can capture in return for assuming price risk.
Keynes used the concept of “normal backwardation” to explain why prices for futures contracts tended to understate the market’s actual expectation of future spot prices. Normal backwardation enabled hedgers (who he assumed to be mostly producers who want to be net short of commodity futures) to pass risk to investors (who must be net long) by enabling investors to lock in a price increase (on average).
The market does not have to be in an actual backwardation. It is enough that futures prices are below the market’s (unobserved) expectation about future spot prices. While this is easier to achieve in a market that is actually backwardated, it is still possible in a contango, provided the forward prices are still below where the market thinks spot prices are likely to rise in future.
In a similar vein, Gary Gorton and Geert Rouwenhorst, in their famous 2004 paper on “Facts and Fantasies about Commodity Futures”, suggested investors could capture an embedded risk premium from running long positions in a diversified basket of commodity futures contracts.
In practice, normal backwardation and embedded risk premiums have long since evaporated at the front end of the curve as index funds and other long investors have piled in and the trade has become increasingly crowded.
REAL BACKWARDATION PERSISTS AT BACK END
But there may still be a premium embedded in far forward contracts. Nominal contango is hiding a “real backwardation” in inflation-adjusted forward prices (as Chart 1 clearly shows). Investors are still being offered the opportunity to buy long futures contracts at a discount to expected future prices, if inflation remains relatively brisk (Charts 2 and 3).
For higher inflation rates, the real backwardation is substantial. Using the Dec 2010 futures prices as a baseline rather than Jun 2010 (which show signs of distress owing to limited storage capacity), current oil prices are trading around $81 per barrel.
If inflation runs at 2-3 percent per year for the next five years, spot prices should rise to between $89 and $93 per barrel by the end of 2015, about in line with the current forward curve, to keep pace with the devaluation of money. But if inflation rises faster than this, or real prices increase, investors should be able to lock in gains.
Gains could be much higher if oil prices rose in real terms to incentivise more exploration and production, and restrain demand, or if inflation averages more than 3 percent. Equally, investors will make a loss if inflation (and therefore nominal oil prices) is lower than 2 percent.
Forward oil prices (like those for other commodities) still offer a risk premium for long investors, and potential to hedge against inflation.
But the effect is likely to be temporary. As more investors shift their positions further down the curve to escape the negative impact of contango, it will force the curve’s back end into bigger contangos as well, and they will gradually compete away the risk premium here too.
Moreover, investors are taking on quite a bit more risk for their “risk premium”. They are taking a view on inflation (>3 percent) as well as real oil prices.
For forward contracts to be worth buying, inflation must average over 3 percent per year in 2010-2015. Moreover the oil market must remain tight for longer.
The prospect of big gains in real prices is much smaller over a 5 year period than over 1-2 years. Both demand-side and supply-side elasticities are much greater over 5 years as consumers and producers have time to make significant adjustments to their behaviour.
Nonetheless, for investors with a bullish medium-term view on the oil market, and more concerned about the prospect for inflation than deflation, far forward crude oil futures still offer good value for the moment.