Hi , R36 Alternative Investments Portfolio Management P.56 Example 9 Solution to 3: “Oil producers hold valuable real options to produce or not to produce. They may not exercise this option unless sopt prices begin to rise. Production may occur only if futures prices are below the current spot price, which is associated with a downward-sloping term structure of futures prices.” anyone can explain the second part above sentence ? “Production may occur only if futures prices are below the current spot price, which is associated with a downward-sloping term structure of futures prices.” thanks in advance!
If futures prices are lower than the spot prices, then there is an incentive to produce as much oil as possible in order to sell it at the higher, current spot price.
If you are an oil producer and you can sell oil at $90 per barrel in the spot market while the 30 day future price is $80 per barrel. You would prefer to produce and sell as much as you can now instead of locking yourself in at $80. If however the spot price is $80 and 30 day futures price is $90, you will stop all production or prefer to store and sell at the futures price that the spot.
Many thanks, bpdulog, me.tega!! I can understand the concept!!!
why isnt the curve simply flat? why is the oil industry more likely to a backwardation structure??
also, in that scenario, if people jump on the futures contracts to purchase oil later, production will have to occur to satisfy those contracts… in the future… even if the selling price isnt as attractive for oil companies. confused.
If the curve is flat there is no risk to offset and hence demand for futures should be non existent. We are talking about global oil which is a volatile and risky market. Futures markets exist to enable producers and hedgers to offset the risk. Producers hold some stick in the process but it is never a done deal ex-post