Commodities - Real options under uncertainty

CFA Level III Portfolio Management
#1

Hello fellow finance nerds, my question has to do with the paragraph below from official CFA text on Commodities:

"Oil futures markets are often backwardated; in these markets, futures prices are often below the current spot price. This may be caused by the existence of real options under uncertainty.68 A real option is an option involving decisions related to tangible assets or processes. In other words, producers are holding valuable real options—options to produce or not to produce—and will not exercise them unless the spot prices start to climb up. Production occurs only if discounted futures prices are below spot prices, and backwardation results if the risk of future prices is sufficiently high. "

My issue is with the last line, production only occurs if discounted futures prices are below spot prices. So I try to ratched that thought out with a scenario: I am a producer with an oil well in my back yard. today, oil is going for $100 a barrel (so that’s the spot price). Then I go on the internet, and see that futures prices on oil with an expiration of 1 month are $200 per barrel. I don’t care what discount rate you’re using, $200 a month from now is not going to be less than the $100 spot price. So according to this rule, I’m like “oh, looks like the discounted futures price is not below the spot price. I better not make those barrels until futures prices start coming down”. Seems like the opposite of what makes sense. Anyone care to explain what is wrong with my interpretation of this rule? I know it’s something, and I’ve clearly done a very literal interpretation of the rule, so they must mean something different than what I’ve understood…

Thanks in advance

#2

if the futures price is below the spot - you are guaranteed that at maturity the price will rise UP to the spot (due to backwardation) so there is an incentive for you as producer.

If however the futures price is above spot (contango curve) in future - your price is going to ROLL Down to the Spot price - which is a loss making position for you as a “producer”.

#3

seems a little extreme to just stop production altogether because the futures price is below the spot price though, as the text is saying with this line here: Production occurs only if discounted futures prices are below spot prices, and backwardation results if the risk of future prices is sufficiently high.

So in my example, if the spot price is $100, and the futures price is $200, I shut down production completely? That doesn’t make sense to me… does it make sense to you? I would be selling futures and producing the shit out of that oil if I was a producer in that scenario - I’d wanna get that $200, which is way more than the $100 that is currently available by selling at the spot price, so I guess I still don’t get it

#4

the futures dealer gets the futures price. that does translate into a profit for the futures dealer- since he would buy at the spot of 100, sell the futures at 200. but the manufacturer himself gets nothing. It makes no sense for the producer since he gets nothing out of this. he is producing below market (if the 200 could be considered the market price at this time).

#5

magicskyfairy , in the situation you mention oil prices appear to be very volatile . What is the certainty that the producer , if he waits until the futures expiry , will receive the $200 for his oil?

If his certainty was 100% , he doesn’t even need the futures market . Indeed , if he is not presently in need of the proceeds from pumping oil , he could wait longer if the futures curve appears contango to the next and the further expiries. Of course producers have hedged the present spot production as well and being producers they would be short oil , so they have to produce at least the amount they have to deliver into the market for the currrent expiration

The only thing producers are certain about is the present shape of the curve. If the spot is $100 and the futures is at $200 , it implies a glut in the storage presently and spot is being sold cheaply . The market expects the glut to resolve by pricing the futures much higher , and producers would take the cue and cut back present production until the glut eases. Normal backwardation would resume with oil rising in the spot and being discounted in the futures for at least the cost of financing .

In other words the futures curve is an excellent price setting mechanism for the marginal barrel of oil.

#6

I think I just interpretted the text to be saying a thing that it wasn’t saying - the wording is confusing. If the producer sees a futures price that is lower than the spot price, he’ll prefer to produce today and sell at the spot price. If the futures price is higher than the spot price, he’ll prefer to delay production, and realize that higher sale price later on. At least that’s what I interpret, not sure if it’s right or not.

My reasoning (about producing in anticipation of the $200 futures price) was actually correct - I will absolutely want to produce for $200, which means that today, I don’t produce (I’ll wait, and then produce later in to deliver on the $200 contract, and not produce on the spot price). The nuance should have been made a little more explicit I think by specifying CURRENT production only occurs if discounted futures prices are below the spot prices. I was assuming no production at all would happen until spot prices go back above the futures price, which is a far too literal interpretation of the sentence. Does that sound about right?

PS, I think I remember u on AF from a couple years ago, did u pass level 2 in 2012?

#7

im still not clear on futures as a hedge and how it affect producers and buyers.

from CPK123

“the futures dealer gets the futures price. that does translate into a profit for the futures dealer- since he would buy at the spot of 100, sell the futures at 200. but the manufacturer himself gets nothing. It makes no sense for the producer since he gets nothing out of this. he is producing below market (if the 200 could be considered the market price at this time).”

why cant the producer be a dealer himself? lets take a big company like Shell, surely they have the resources to take on all the roles needed to profit off the chain of processes?? use dates for clarity in Jan 1, SPOT is $100 and the 3 months futures (expire Mar 31) are at $50. this is a case of Backwardation.

if the futures price is below the spot - you are guaranteed that at maturity the price will rise UP to the spot (due to backwardation) so there is an incentive for you as producer.

If however the futures price is above spot (contango curve) in future - your price is going to ROLL Down to the Spot price - which is a loss making position for you as a “producer”.

what is meant by the guarantee of prices rising UP to spot? lets say that today is Mar 30. the spot price of oil now is around $50, no?

thanks in advance for any explainations!

#8

IIRC backwardation is because more producers are looking to hedge (more future supply than demand) and contango because more consumers are looking to hedge.

If spot price is $100 today and $200 in x months, the producer could very well do a cash-and-carry. Produce now, store, go short on the future and deliver at expiry after x months. Why not?

#9

Lettuce.

#10

I agree with naren_, and that idea of consumers hedging in contango, and producers hedging in backwardation. That is something I still remember from CFA lvl 2. In backwardation, the term structure of futures is negatively sloping, and this upsets producers - they think “holy shit, this could get bad, I’m going to lock in a price today by selling a futures contract now, and make sure they don’t get worse”. So to stick with my example, if oil is $100 a barrel today, but the 3 month futures price is $50, it may well be that the expected spot price is $60, but I, as a producer, really hate the idea that I *might* have to sell my barrel for $40 in 3 months, so I lock in my future at $50.

The exact opposite is what happens in contango with a positively sloped term structure of futures prices, except that in the contango scenario, it is the consumers who are more paranoid about locking in a price by going long on futures to avoid being caught with their pants down if prices go much higher than they anticipated.

Getting back to the original question, there is still this statement: Production occurs only if discounted futures prices are below spot prices, and backwardation results if the risk of future prices is sufficiently high.

The answer to why that is true is just this: If the producer sees a spot price of $100, and a futures price of $200, he’d have to be an idiot (or very desperate for cash) to do production today for the measly price of $100 when he can just sell a futures contract, STOP production (for now), and initiate production in 3 months time to get that $200 payday that he committed to.

If the discounted futures price, however, is only $50, (ie below the spot price of $100), then I am going to produce the shit out of my well and sell as many of those bad boys as I can while the price is still $100, because $50 sucks.

And that is just about all I need to know about this part of this topic, unless someone sees some glaring weakness in my reasoning/interpretation above, and if so, I would appreciate the insight.

Also thank you to those who responded, it’s appreciated.

#11

why not? because storage costs money , that’s why. If the spot is at $100 while normal futures is at $200 , it is quite likely that storage is full and the storage of the additional barrel could be quite expensive . Add that to the spot price of oil now and it could be more than $200 . ( ok we’re all exaggerating here some )

#12

Oil market has 3 types of players officially recognized as such by the CFTC .

CFTC calls producers and consumers of oil ( first two types ) as Hedgers or commercial traders. They expect these folk to actually take delivery or produce the oil in fulfillment of the contract they hold at expiration ( i.e. long or short oil futures)

CFTC calls the middlemen , who will never take delivery of oil and who will never actually produce the oil , as speculators , also known as non-commercial traders.

Speculators must exit their positions 1 days before expiration. They can do so by doing an opposite trade ( buy for their short position or sell for their long one ) . All trades have the exchange as a counterparty . 1 day before expiration , there are roughly double the number of contracts open than oil be delivered or sold . So many contracts will be extinguished unfulfilled . The price of the futures contract converges to the spot by the time it expires. set by a consensus among all the players , and by the realities of supply and demand and storage / shipping availability .

Because there are many producers and consumers , there is always some volatility in prices ( sorry Shell is not dominant and can’t set the price on its own ) . In fact due to the volatility , producers hedge their production so they can lock in a profit , even if they have to give up some of it to the speculator. In return the speculator carries the risk of the price going against him. So the futures contract is a vehicle to transfer risk and ensure supply & demand takes place without interruption.

The consumer of oil ( mostly refiners or airlines ) also needs to see their expenses adjust to the market smoothly so they can sell services and goods ( such as gas or airline tickets) and extract a reasonable profit. Again they pay part of this profit to the speculator who provides the risk management.

Futures rises or falls to the spot at delivery . If it didn’t there will be arbitrage which will force it to happen.

#13

thanks janakisri !!!

ok lets use the example of 1st Jan spot of $100 and the $50 future expiring on 31st Mar

and i quote cpk123 comment

'vif the futures price is below the spot - you are guaranteed that at maturity the price will rise UP to the spot (due to backwardation) so there is an incentive for you as producer."

this is a case of backwardation

so if a producer want to lock in a certain amount of profit, he will short futures. including the storage costs and all, i assume that there is no surprise shocks and the future is priced correctly, can i say that the SPOT price of oil on 30th Mar will be around $50±??

from the perspective of a producer looking at the prices on 1st Jan, $100 to $50± is a downward move, no? the producer incentive is to lock in a certain amount of profit using futures, and of course he gives up a certain part of the profit for this certainty. so what is the “guarantee of prices rising UP to spot”? thanks

#14

producer produces oil. he will not in a right frame of mind short futures too - since if he does that he is expecting the price to drop in order for him to make a profit on his hedge, while the future itself has absolutely no value without him producing the oil. and that would mean he will be making a loss on his real line of business.

#15

The producer’s natural contract is short futures , since he will deliver oil. If he shorts a futures contract @ $50 per barrel , he is obligated to deliver that barrel , say 1 month in the future , and receive $50 . Does he make a profit? Yes , if his cost of production ( and any other costs he has to pay ) sums to less than $50. Could he have foreseen this profit ? Yes reasonably if he wass experienced and knew what his costs would have been , sure . Has he locked in the profit? Yes , since he shorted the contract and he is assured of it.

Notice we’re not looking at the actual price in a months time . It may be $65. The speculator who took the long side of the futures contract has made the profit on the futures contract , since he pays $50 to the producer , receives the barrel and sells it in spot market for $65 and keeps the $15 profit.

The speculator is happy , since he made the right call , the producer is happy since he locked in his profit ( $50 - cost ).

Now if oil per barrel winds up at $45 per barrel on expiration , the speculator is unhappy ( having lost $5 on the deal ). The producer is just as happy as before , since he is seeing exactly the same profit ( $50 - cost).

So the speculator is taking the risk of fluctuating price , while the producer has passed on the risk in return for a calculated profit.

You can reverse this argument when the hedger is an airline . They are natural longs and the speculator is their short counterpart. The consumer is guaranteeing to take delivery , in return for a fixed price , which is the price they paid for the futures contract.

no one can foretell exactly what spot will be at delivery time . we only know that the fuures price gradually converges to the spot at delivery time. But producers and consumers can’t operate under the uncertainty . They would have hedged much earlier to delivery time. The risks of prices are borne by CTA’s and speculators , who may take offsetting positions in swaps or options to mitigate some of their risk . depending on how much they offset i.e. hedge , their leverage could be large or small , i.e make large amounts of profit or loss or smaller amounts

#16

As time progresses, futures will converge to spot prices due to arbitraguers, who buy commdity and short futures in case futures trade for more than spot. This in turn causes demand for corn to increase bringing the prices more or less equal.

#17

i sort of get the converging part. but say in the case of backwardation, does the futures prices move downwards? or up?

#18

There is no guarantee that the futures will move up when there is backwardation currently. The only guarantee is that it will converge to the spot at expiration. If spot stayed where it was or not moved in the wrong direction given expectations , up until expiration , then the futures price would have risen if there had been backwardation. And if spot stayed flat or not moved much ( in the wrong direction) then under contango it would have fallen from where it was

#19

thanks for the clarification!