I’m drawing a blank here. I understand that producers hold real options and won’t exercise those options i.e. produce oil/goods etc, unless the spot price rises. What I’m confused about is how does that decrease the price of futures contracts to push the market into backwardation?
Thanks.
Wow, how did I miss this part of the curriculum?
I always thought of it as a factor of production hedgers versus consumption hedgers, the risk free rate, any convenience yield, and storage costs.
I’ve never heard it put in terms of real options. Where is this in the text?
i believe it factors into the convenience yield. For a producer having the convenience of being able to keep inventory on hand, if someone is going to entice him to give up those real options it needs to be at a lower price (you must compensate him for giving up his convenience yield by providing lower priced future delivery).
Opposite of storage costs where futures cost more because you have to compensate the holder of, lets say, physical gold for custodial fees and such.
I probably did not word-smith this in an optimal fashion but that is the idea.
Thanks Mark. I still don’t follow though. What do you mean at a lower price? I can see why the spot price rises because the producer wants to be able to sell it at a higher price to make money so they hold back supply until it rises high enough for them to be earn a profit they seem reasoanble. Why would a producer want lower futures prices? How does that benefit them? Why would they want to sell their future goods at lower prices? I can see if they had to buy the goods then wanted to sell them, then u short the forward, price goes down, you buy at the lower price and sell at the higher agreed upon forward price. But, if you’re producing the goods, you’re not buying anything. You already have the inventory on hand. I’m confused lol.
in order to prevent themselves from running out of production material (inventory) they buy up earlier. If they need to be stopped from holding things in inventory (hoarding) they need a guarantee (kind of, my words) that they can get the material later at a lower price (which is the futures price). If the futures price is lower - they would give up hoarding and buy the futures. And if that happens - then the price of the futures < spot price in the future (and this causes the backwardation).
V5, P55.
“Convenience yield reflects an embedded consumption-timing option in holding a storable commodity.”
“Real option is the option to produce or not to produce” – this is very similar to the convenience yield.
Both benefit the producers or holders, so the producers are willing to accept a lower future price when they short the futures to hedge the market risk. If they don’t hedge the price risk, they still have the option to produce or not to produce.
Your explanation makes sense CPK. These producers want it all huh? I want to sell you my product now at a higher price and I also want the benefit of being able to buy it back later at a lower price. Seems wrong to me.
it is not buying back the product. It is buying the raw material that goes into the product.
Backwardation for producers has a simple explanation:
If today’s price is higher than futures price , produce the goods today.
Otherwise defer into the future , since you get higher price in the future.
If there is a penalty for the producer in keeping the commodity or goods “un-produced” ( i.e. a lowering of price ), then they will be induced to produce immediately to capture the premium of spot over futures price.
If there is a reward for producing the goods later in the future ( i.e. a higher price ), , they will be induced to sit tight and wait it out.
Ok So Oil producers will produce only if current spot price is higher (means there selling price is higher) If futures prices (means implied spot rate) is higher so they would hold back production & will produce later. If futures is low (means implied spot price is low) it makes sense to produce now & sell at current spot (which is higher than futures)