REal options

Fin quiz mock exam 3 PM Q 17

(referring to CFA Vol 5 SS 13 Reading 26 pages 49-50, 52)

It says ‘The real options held by oild producers will only be exercised when spot prices begin to rise. These real options will be used to determine whether production should be done or not. Production will only occur when futures prices are below the current spot price i. e., a downward sloping term-structure of forward prices. Oil producers will not exercise their production options when futures markets are in contango’.

Can anyone throw some light on the logic why production will happen in backwardation.

Thank you

There is no incentive to produce at the present time if the spot is less than the future price. For them to produce they would want the spot higher otherwise they would wait.

There was another thread on this a while back (1 - 2 months, maybe). Try searching for that one; it had a good discussion.