The Financial Instruments

There are mainly three types of oil commodity markets (Hanesson 2005):

• The spot market for immediate delivery.

• The forward market for future delivery at a predetermined price.

• The futures market for standardised contracts about future delivery.

A purchaser may want to buy future deliveries to reduce the risk of price changes (hedging) or profit by speculation. Hedging can be done by, for instance, a buyback alternative. The refiner of crude oil buys futures in October 2005 that are due to fall in February 2006. The futures are bought for $40 per brl while the spot price is $43. Then in January 2006 the producer sells his futures for $x and then buys oil spot for $y. If x ≈ y then the realised price would be around $40 plus transaction costs. The cash flow for the refiner is then (simplified): -$40 +x – y. It is also possible to hedge in a different product, for instance, gasoline for naphtha.

The crude oil term structure is presented in figure below. We see that the first figure illustrates a lower barrel prices for future contracts with constant (fixed) prices for increasing maturities, while the nominal prices (maturities nominated to a variable price, affected by the current spot price) have an increase prices when maturities increase. The nominal term was in contango (explained later) and the constant term went into backwardation (explained later) few years later. This means that the price could be locked in 10 years later at a lower futures price than the prevailing spot price.

Figure 52 Crude Oil Term Structure, Nominal and Constant Futures Prices, Gabillon ‘94

When exchange rates are taken into account, the term structures changes a bit. This is illustrated by figure below.

Figure 53 Crude Oil Term Structure for different Currencies, Gabillon ‘94

There is a convergence of spot prices and futures prices, and their movements are somewhat parallel. If the market thinks $40 per barrel is a “correct” price and the price has been stabile at that price for a long time then the futures price would be pretty much the same as the spot price. The spot price usually varies around the futures price depending on the physical position of the commodity. If the inventory levels are lower than first predicted then the spot price would get higher than the futures price since buyers would want to secure its crude supplies. The relationship between spot prices and futures prices can be expressed by the

futures price being dependent on the current price of the asset and cost of carry, given in the following simplified equation from Hanesson (2005):

F < S (1+r) + c where F = futures price S = spot price

c = storage cost

r = risk less interest rate

Formula II The Relationship between Spot Price and Futures Price, Source:

Hanesson 2005

Note that this equation does not include “the time of maturity”-element that may affect the futures price. If this equation should not hold then it would be cheaper to hedge by purchasing physical crude oil and store it rather than buying it at futures price. By presenting the convenience yield as the difference between the right hand side of the equation from the left hand side, we get following equation:

Ω = S (1+r) + c – F

Formula III The Convenience Yield, Hanesson 2005

The convenience yield has been defined by Brennan (1989) as “the flow of services which accrues to the owner of a physical inventory but not to the owner of a contract for future delivery”. When S < F then the convenience yield is small and the market is in contago.

While the market is in backwardation when S > F since the convenience yield is large. Since the interest rate is strictly positive and there is a cost of carry (c), F should be larger than S.

However, the market is not always in contago. Backwardation happens when it is preferable to hold inventory for strategic reasons although it seems unprofitable in the short term. The physical nature of oil and its political/strategic importance give the commodity a distinct

structural preference. Oil cannot be produced and distributed to cover sudden demand but with a time lag. In addition, processing centres and refineries are often distant from consumers, making the lead time longer. This makes the elasticity of demand for refined products inelastic, putting an upward pressure on physical prices.

On figure below you see how backwardation explodes during the given winter since there is a high expectance of higher future prices.

Figure 54 The Backwardation Effect due to Winter Season, Gabillion ‘94

The figure illustrates how the term structure is for a market in contago. The “cash-and-carry”

arbitrage increases with the time length.

Figure 55 The Term Structure of Forward Price when Market in Contago, Gabillion ‘94

Crude oil producers hold reserves and they might be exposed to drop in prices. They are then

“short hedgers” to cover the short-term exposures from their sale contracts and inventories.

This will give a downward pressure on the future prices due to increase in number of sellers going short since producers want the highest price. However, when there is a perception that prices are already at a historical low then the producers are reluctant to cover their exposure since there is a high probability of an increase in prices. For the refiner the situation is slightly different since it involves both crude oil and refined products. When there is a large risk of prices of crude oil and refined products to fall in price to a bottom low then the refiner wants to go long on crude oil (buy position to profit from higher crude oil prices later) and short on refined products (sell position to profit from higher prices now), and thereby hedging their refining margin. As a result, refiners transfer financial risk between the two forward curves, crude oil and refined products, thereby securing a refinery margin.