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Over the last 5 month the prices for oil dropped by about 40% leaving many market commentators with anticipations of further drop. Albeit there is no laws of nature that prohibit another leg down, this scenario seems to be of low probability. The reasoning behind this rather bold prediction lies in the realm of the fundamental forces shaping the trends for the price of oil.
As any other other price, set in the free market place, the oil price is subjected to two fundamental forces – demand in the spot market and supply in the market of futures contracts. The spread between short dated futures or spot prices and long dated futures sets the tone for the further price dynamics.
For many shale oil drillers in the USA selling the long dated futures contracts is a viable tool of financing their operations. At elevated prices – the prices above the cost of production – selling of futures by oil producers exerts downward pressure in the oil futures market leading to diminishing contango spreads and even to backwardation. If the spot prices go below this level this pressure subsides, naturally setting the floor in the market of long dated oil futures.
Any further drop in short dated futures or spot market will not lead to concomitant down moves for long dated futures, but rather lead to increase in contango state. The latter creates conducive conditions for oil hedgers – namely, enterprises involved in storing oil – to buy oil, thus exerting buying pressure on spot prices.
These countervailing forces might lead to range bound price dynamics. Any further drop will lead to additional buying from hedgers, while run up will be met by extra selling pressure from oil producers.
As any other other price, set in the free market place, the oil price is subjected to two fundamental forces – demand in the spot market and supply in the market of futures contracts. The spread between short dated futures or spot prices and long dated futures sets the tone for the further price dynamics.
For many shale oil drillers in the USA selling the long dated futures contracts is a viable tool of financing their operations. At elevated prices – the prices above the cost of production – selling of futures by oil producers exerts downward pressure in the oil futures market leading to diminishing contango spreads and even to backwardation. If the spot prices go below this level this pressure subsides, naturally setting the floor in the market of long dated oil futures.
Any further drop in short dated futures or spot market will not lead to concomitant down moves for long dated futures, but rather lead to increase in contango state. The latter creates conducive conditions for oil hedgers – namely, enterprises involved in storing oil – to buy oil, thus exerting buying pressure on spot prices.
These countervailing forces might lead to range bound price dynamics. Any further drop will lead to additional buying from hedgers, while run up will be met by extra selling pressure from oil producers.
