r/investing Apr 14, 05:46 AM
Thesis: Converging Spot and Futures Prices So I’ve been seeing a lot of speculation and confusion about why oil futures have remained so low despite the historic supply disruption, and why the spread between futures and physical prices is so big. I have a bit of a background in oil, so I’ll try to explain it based on my understanding. Just to be clear, this is something that’s baffled a lot of commodity experts, so I’m not claiming this is the 100% accurate assessment, it’s just my personal thesis at the end of the day.
Before we jump into the conflict and the situation with Hormuz, we need to first understand what was going on with oil markets leading up to the war:
The Cash and Carry Trade
Before the onset of the war, a lot of traders were engaged in what is called the “cash and carry trade.” In a healthy, stable oil market, the futures price curve is in “contango.” This means that future prices are higher than spot prices. Why? Given stable supply and ample storage, the future price of a barrel of oil is typically higher than it is in the present due to cost of storing oil (storage, interest, insurance).
How it works: In a cash and carry trade, traders take advantage of this contango situation by buying cheap physical oil in the spot market and simultaneously short selling a futures contract for delivery several months out. They store the oil, sell the futures contract then profit the difference. In normal situations this is a stable, low risk profit.
This is the “carry.” Sounds too good to be true right? Well 99% of the time it’s actually pretty safe. But sometimes you end up with our current disastrous situation, and you might just be fucked.
Supply Disruption and Backwardation
In extreme circumstances when there is a great supply or demand shock, the futures curve reverses and we enter a situation called “backwardation.” In backwardation the cost of spot oil is GREATER than the cost of futures, because buyers want oil NOW NOW NOW. This spikes the price of immediate physical oil, making it higher the cost of futures because the market expects the shock to subside with time and for future demand to settle.
We are currently in this situation. The closure of the Strait of Hormuz is easily the largest physical supply disruption we’ve ever seen, period. Nothing else compares. There is a massive shortage of oil and buyers are desperate for any barrel they can get. They want it now.
This backwardation scenario is a nightmare for cash and carry traders. Why? Because if you were already running this trade before the war started, assuming continued contango, you are now trapped in this backwardation. When the war hit, the front month contract (which they were short), exploded in price. These traders are now facing huge, open ended losses. Every dollar that oil rises in the front-month, the bigger their loss.
Under this circumstance, the ideal scenario for these traders would of course be for the war to resolve and for prices to return to normal. As the war drags on and the su