Futures in crude oil price
Futures not only reflect the actions till date but also incorporate the likely course of action. The future prices show what traders expect to happen. Futures allow companies or traders to purchase contracts to buy or sell crude oil at some time in future.
The length of individual future contract varies and most common future contracts are up to one year in time. Future prices are based on best estimates of various events that may happen and how they would impact crude oil supply and demand. Since they indicate the likely price of crude oil at some distant time, future prices are a reflection of market expectations.
During peaceful times, oil futures generally slope upwards. This is due to two reasons. First, it reflects oil storage cost in future prices. Companies need to store oil and pay for storage costs if they want to deliver oil in future. These storage costs are added to spot prices to arrive at future prices. Oil supply is not unlimited and it takes sufficient time to bring new oil wells into production. The demand for oil on the other hand keeps on increasing. So under ideal conditions, oil prices would rise over time.
Iraq’s invasion of Kuwait caused two changes in oil futures in August 1990. First impact was to increase oil future prices for all future contracts. This is because of uncertainty about the availability of crude oil in future. Table 2 shows the production and consumption of oil in 1989 in OECD countries. OECD countries consumed 40.1 million barrels per day of oil and produced only 18.8 million barrels per day. Thus the demand supply gap in OECD countries was 21.3 million barrels per day.
On the other hand, OPEC countries had a massive over supply of crude oil This excess supply was very essential to meet the shortage in OECD countries and any disruption to this vital source would lead to worldwide shortage and high prices. The disruption in Iraq and Kuwait oil production during the First Gulf War resulted in 4 million barrels per day reduction in crude oil supplies. This immediately led to increase in prices as suppliers priced in the uncertainty of oil availability. The oil future prices rose for all future contracts initially because market didn’t know how long it would be before supplies would be restored.
The second change in the future price curve is the change in its slope. During war times or periods of uncertainty, the slope of the future price curve turns negative. This reflects the initial jump in the oil prices due to short supply. The future prices then sloped downwards because of the expectation that the war wouldn’t last long.
The spot price in the first week of August 1990 was very high. It jumped from around $20 per barrel to over $40 per barrel. As US announced its decision to send armed forces to Saudi Arabia, it gave market an expectation that neither the supplies would drop significantly more nor the current war scenario will hold for long. US presence in Saudi Arabia deterred Iraq to attack Saudi Arabia and further disrupt oil supplies. If US hadn’t sent its armed forces to Saudi Arabia, markets were anticipating a war with Saudi also. A reduction in Saudi oil exports would have severely crippled oil exports. Also as US expressed its desire to free Kuwait, markets knew the disruption in Iraq and Kuwait oil supplies would not last long. So future crude oil prices came down from the high spot prices.
The expectation of shorter conflict was alone seen in the flattening of future prices. Curve flattening occurs when the price differential between adjacent periods decreases as the length of future contract increases. As an example, the difference between the future price in October 1990 and November 1990 was more than the difference between the future prices in March 1991 and April 1991. This was due to the fact that oil traders had more faith in quick resolution of the crisis and Iraq’s inability to launch a major strike against Saudi Arabia because of presence of US armed forces. The buyers could anticipate an easy availability of crude oil in future compared to the first week of August and hence were less willing to pay a premium.
The spot and future crude oil prices after Iraq’s invasion of Kuwait show that the market was uncertain about future availability of oil. Spot prices jumped rapidly. But as time went by and with US declaration of its intention to come to the rescue of Saudi Arabia, markets reduced the war premium. Future prices lowered sharply but were still higher than the prices in the first half of 1990. When US attacked Iraq in January 1991, future prices declined sharply in anticipation of quick end to the crisis. Looney (2003) said that buy when you hear the sound of the cannon and sell when you hear the sound of the church bells
Yamani (1991) said that since long political events in Middle East have a major impact on oil market to the extent that under crisis market disregards the fundamentals. This was clearly visible during the First Gulf War. Iraq’s invasion of Kuwait was only a temporary disruption in oil supplies. It wasn’t difficult to make that the crisis will last for months or at most a year rather than for years. The world had enough stocks of oil to take care of shortfall for months. And other OPEC countries would have increased their production to take care of shortfall. So it wasn’t difficult to conclude that oil prices were incorporating more war premium than what was due.
Yet at the same time, market is uncertain about the duration of the supply disruption. And also there is uncertainty about what would be addition by other oil exporters. These are particularly high at the beginning of the crisis. Even though market knew that oil supplies would be restored, yet it pushed the prices to over $40 a barrel. But the price hike on the day after the attack was only up to $28 a barrel. Then what caused the further hike in oil prices.
Yamini (1991) mentioned that during crisis, holders of oil stock are unwilling to use their stocks to smooth price movements. US has Strategic Petroleum Reserves for such crisis times only. But the US government sees it as a more strategic defense thing rather than something to be used for price stabilization. It didn’t initially release any oil from SPR to lower prices. Only when the war ended in February 1991, the US government released oil from SPR to the commercial buyers.
Tags: crude oil supply, first gulf war, oil futures, price of crude oil, worldwide shortage
