Thursday, 22 May 2008

"But what do the market say?"

The most often heard objection to a near peak peak oil hypothesis is this:

"Well, if the oil production were to peak, wouldn't the markets know this? Wouldn't the fact be somehow reflected in the prices?"
This used to be difficult to explain sufficiently to market fundamentalist bozos, who believe that 'markets know all' (i.e. omniscient). Trying to explain to these people the notion of information asymmetry is a true exercise in futility. Paradigm shift registers equally bad in their conceptually active vocabulary.

But now the markets have changed. Take a look at these curves.

Crude oil futures markets have gone from inverted to normal. That is, the price of a futures contract that supposedly guarantees a delivery of oil in the future is now going up as a function of contract maturity. Or more simply: the longer you wait, the more you will have to pay for your oil (according to the futures market).*

It doesn't help that the futures markets have been consistently wrong about the price of crude oil for the past six years. The markets are in constant normal backwardation. That is, those crude oil futures have earned a lot of people quite nice profits, because the markets have priced them way too low.

Jeff Veil wrote a good piece about this @ the Oil Drum, although the definition of contango is used somewhat confusingly. But that is beside the point as the fundamental change in price is what matters, not what we call it.

The change of the futures curve market to normal is funnily enough not 'normal' for crude oil futures market. It is in fact abnormal to futures traders.

In fact, traders quoted in The Financial Times yesterday had this to say:
"Veteran traders said they had never seen such a jump and said investors were increasingly betting that oil production would soon peak because of geopolitical and geological constraints."
This may well be it. The crucial tipping point for understanding. When the markets find out something, that something becomes - for better or worse, true or not - the truth. Politicians will soon follow, all singing in merry unison.

The question on everybody's lips is: What's going to happen next?

Brace yourself for a train crash in slow-motion.

* PS. Markets assume that a futures contract guarantees a delivery of goods for a contractual price on the date of the maturity. However, this only works as long as the markets function without fault. When the markets break down, derivates like the futures contracts can turn worthless and guarantee nothing about delivery. This is not as imaginary as it sounds. In general, derivate markets fault when they can no longer function. In the case of oil futures, until the stuff just isn't there in terms of the volume traded. So if you're thinking of dipping your toes into the futures market, proceed with caution: funny paper isn't the same as a barrel of oil.