Oil prices, unlike most other items, are not solely influenced by supply, demand, and market sentiment toward the physical product. Rather, price determination is dominated by supply, demand, and emotion toward oil futures contracts, which are frequently traded by speculators. Commodity market cyclical tendencies could potentially play an influence. Regardless of how the price is ultimately established, oil appears to be in high demand for the foreseeable future, based on its use in fuels and a wide range of consumer goods.
Do oil futures pricing aid in the forecasting of future oil prices?
The price of oil futures is frequently used as a proxy for the predicted price of oil in the future. Some people also believe that futures contracts, especially actively traded contracts, are stronger predictors than econometric forecasts based on historical data.
Are stock returns predicted by oil futures prices?
The cross-section of oil futures prices is used in this paper to investigate stock return predictability. The curvature factor of the oil futures curve predicts monthly stock returns, according to principal component analysis: a 1% monthly increase in the curvature factor predicts a 0.4 percent monthly decline in stock market index return. This pattern is prevalent in non-oil industry portfolios, but it is not present in oil-related portfolios. The curvature factor’s in- and out-of-sample predictive value for non-oil stocks is strong, outperforming several other predictors, including oil spot prices. The curvature factor’s ability to forecast supply-side oil shocks, which solely effect non-oil equities and are hedged by oil-related stocks, gives it predictive value.
Do spot prices predict futures prices?
Futures market prices can occasionally be used as spot price estimates. They don’t in other circumstances. The federal funds futures market, for example, can be used to forecast interest rate adjustments by the Federal Open Market Committee (FOMC). When making a soybean production loan, a bank loan officer should not rely solely on soybean futures prices to estimate future spot prices. To make matters even more complicated, a company that wants to estimate oil prices six months from now can occasionally rely on the futures market for a realistic forecast, but it can sometimes fail to do so.
To accommodate for these various eventualities, commodities must be divided into three categories: non-storable, storable with significant inventory “overhangs,” and storable with modest stocks.
Non-storable Commodities
Non-storable commodity futures prices reflect merely market projections of future supply and demand situations. These are the only commodities for which futures prices may be used as easy forecasting tools. Non-storable commodities are perishables, or items that vary in quantity or quality frequently. Eggs, for example, are considered non-storable because they spoil quickly; a fresh egg is not the same as an egg that has been sitting in the refrigerator for a month.
Non-storable commodity futures prices might differ dramatically from spot prices due to anticipated changes in supply or demand. Assume the market anticipates a decrease in egg supply in three months. The price of three-month futures would rise above the current spot price. Because vendors cannot keep the eggs (take them out of the spot market) to sell later, spot pricing would be unaffected. They have to sell today’s eggs at today’s market prices. In contrast, if the market expects egg production to rise in the next three months, the futures price will fall below the unchanged spot price.
There is also a futures market for federal funds, as well as an interbank market for reserves (deposit balances held by banks at the Federal Reserve). Because a bank cannot store reserves today to meet future reserve requirements, these products are non-storable. Federal funds futures pricing can be used to infer market expectations for future interest rate changes by the FOMC. 2 Current federal funds market conditions have no bearing on future conditions, and vice versa.
Storable Commodities with Large Inventories
Futures prices simply represent the current spot price plus carrying costs for storable commodities with huge inventory overhangssay, several months’ worth of consumption. Carrying costs are the interest and storage fees that would be incurred if the commodity were retained in inventory between the current date and the maturity date of the futures contract. For example, the market price for soybeans on November 1, 2001 was $4.26 per bushel, but the January 2002 futures quote on November 1 was $4.34.3. The eight-cent difference represents the per-bushel carrying costs of soybeans for two months.
Why are carrying costs required to link spot and futures prices? If the soybean futures price was higher than the spot price by more than carrying costs, an arbitrageur could make a guaranteed profit by selling a soybean futures contract, borrowing money to buy soybeans in the spot market, and delivering the soybeans to the futures contract buyer on the settlement date. A risk-free profit would be guaranteed because the difference between the futures price received and the spot price paid would more than cover carrying costs. If the futures price went below the spot price plus carrying costs, market players would sell their inventories in the spot market and buy futures contracts, putting downward pressure on the spot price while simultaneously increasing upward pressure on the futures price. As a result, traders seeking risk-free profit opportunities would soon return spot and futures prices to the above-mentioned relationship: The spot price plus carrying expenses will be the futures price. Traders, in effect, distribute the vast existing inventory across time, based on the cost of carrying inventory.
Storable Commodities with Modest Inventories
For storable commodities with low current stockpiles compared to current consumption needs, interpreting futures pricing is a little more difficult. We must distinguish between two scenarios in these marketplaces. The non-storable commodities analysis is used when futures prices are lower than spot prices (a pricing structure known as backwardation). The futures price is the market’s prediction of the spot price in the future. The study of storable commodities with substantial stockpiles applies if futures prices are higher than spot prices (a contango market).
The oil futures market is an excellent example of a storable commodity with low inventory levels. If future oil supply is predicted to grow, futures prices will decline in relation to spot prices. Although arbitrageurs might potentially benefit by selling oil on the spot market when the spot price is greater than the futures price, inventory shortages prohibit this. The spot price for a barrel of crude oil on November 1, 2001 was $21.70; the November 2002 futures price was $21.27.4 An arbitrageur could clearly profit by selling spot oil in 2001 before the price drops, but inventory limitations prohibit this.
If, on the other hand, future supply is predicted to be limited, future spot prices are expected to be higher than present spot prices. Arbitrageurs might buy “cheap” spot oil with borrowed money, sell oil futures contracts, and store the oil for future delivery, so the futures price could not soar arbitrarily high above today’s spot price. The arbitrageur pushes the spot price higher and the futures price lower by taking advantage of projected high future prices and the storability of oil. This is the same issue we discussed earlier for commodities with substantial inventory overhangs. The gap between the futures and spot prices represents only the carrying costs in this scenario, not the market’s estimate of future spot prices. As a result, futures market pricing for storable commodities with relatively small inventory overhangs must be viewed with caution.
Will the price of oil rise in 2021?
Crude oil prices will fall from 2021 levels, according to our January 2022 Short-Term Energy Outlook (STEO). Brent crude oil, the international pricing standard, averaged $79 per barrel in the fourth quarter of 2021. (b). Brent will average $75/b in 2022 and $68/b in 2023, according to our projection.
The drop in prices is due to a shift in global petroleum inventory levels from decreases in 2021 to gains in 2022 and 2023. When demand exceeds production, global petroleum inventories fall, and when production exceeds consumption, inventories rise.
The outflow of 1.4 million barrels per day (b/d) from global petroleum stockpiles in 2021 contributed to increased crude oil prices. After the COVID-19 epidemic began in 2020, petroleum demand returned quicker than petroleum output, resulting in these inventory draws. We anticipate that petroleum output will rise in 2022, while consumption growth will stagnate, resulting in an increase in global petroleum stockpiles.
We forecast a 5.5 million b/d increase in global petroleum output in 2022, driven by increases in production in the United States, OPEC, and Russia, which together account for 84 percent of the gain, or 4.6 million b/d. Increased tight oil production in the United States, as well as gradually increasing crude oil production from OPEC+ (which includes OPEC members and Russia), will account for the majority of increased crude oil production, according to our forecast.
We estimate that worldwide petroleum consumption will rise by 3.6 million b/d in 2022, owing to increased consumption in the United States and China, which account for 39 percent of the growth. Global petroleum stockpiles are expected to rise by 0.5 million barrels per day in 2022, putting downward pressure on crude oil prices. Brent crude oil is expected to fall from $79 per barrel in the first quarter to $71 per barrel in the fourth quarter of 2022, according to our forecast.
Is now a good time to invest in oil?
You could think that oil production and demand peaked a long time ago if you read the headlines in most newspapers, especially with the rise of solar, wind, biodiesel, and other green alternatives. The influential “Club of Rome” coalition of businessmen, scientists, economists, and government officials propagated the concept of “peak oil,” which proved out to be completely incorrect.
The Limits to Expansion was published in 1972, and it was an extremely negative analysis based on an MIT computer simulation of economic and population growth, as well as scarce resources. According to the estimate, all known petroleum reserves would be depleted by the end of the century if consumption levels remained constant. Gas and petroleum would be extinct by 1982 if consumption rates continued to rise.
What happened was that we improved our ability to locate and extract oil and gas! This was owing to advancements in technology as well as fresh discoveries. We now produce 28 percent more oil in the United States than we did at the previously acknowledged “peak oil production” era of 1970. Today, the United States leads the world in oil production, significantly outperforming Saudi Arabia, which is in second place.
Myth #2: Alternative energy is where all the opportunity is!
The truth is that global energy demand is continually increasing, and this demand is being satisfied by both alternative energy and oil and gas expansion. We anticipate that energy will be a “both/and” game for years to come, rather than a “either/or” issue.
Alternative energy is a burgeoning business with a lot of room for expansion. For environmental grounds, it is convincing. It also comes with a lot of danger and expense, some of which has been borne by taxpayers.
Some green energy technologies have proven to be successful. Solar and wind energy are becoming more affordable. Solar energy has proven to be so efficient that solar energy storage has become a profitable industry. Electric vehicles are becoming increasingly popular and attractive, which leads to the next urban legend:
Myth #3: Electric vehicles have decreased the demand for gasoline.
While energy supplies are diversifying in the United States and around the world, which is a positive trend, demand for oil and gas has not diminished. Oil consumption continues to rise, particularly in China and India, as well as in the United States. Since 2006, demand for oil has consistently climbed, as shown in the graph below.
Despite the rise of electric vehicles, demand for all types of energy has only increased as a result of population growth and changing lifestyles. Even as more people purchase electric vehicles, there will always be a demand for oil due to the use of plastics (which are manufactured from petroleum) and the use of diesel in trucks and heavy equipment. (The eia.gov chart below does not include the most recent quarter.)
Myth #4 Oil companies and investors can’t make money at $35 an barrel!
Companies in Texas, for example, are profitable even at $18 per barrel. However, for the shale business to be successful, higher barrel prices are required. We do not advise you to invest in shale companies. Even at current barrel pricing, however, there is a big potential!
Wouldn’t the stock market be the best way to have exposure to oil and gas?
Most likely not. Investments receive large tax benefits in order to encourage the country toward energy independence. This means that drilling costs, from equipment to labor, are tax deductible up to 100% in the oil and gas industry. Oil and gas investments are a great way to offset income or gains from other sources. For many people, this makes oil an excellent investment!
Oil and gas can be purchased in a variety of ways, but stocks are not one of them. Let’s take a look at three possibilities and some of the benefits and drawbacks of each:
Stocks and Mutual Funds
ETFs, mutual funds, and large and small-cap equities are all examples of this. Because most gains are re-invested, stocks offer limited upside for shareholders. Oil spills and other unfavorable headlines can have a severe impact on large corporations and their stock prices.
On the plus side, an oil-and-gas mutual fund or exchange-traded fund (ETF) provides some risk protection through company diversification. If you don’t have a large chunk of money to invest, the stock market can be your only alternative.
Unfortunately, shareholders will miss out on one of the most significant advantages of investing directly: tax deductions!
Equity Direct Participation Programs
The most profitable approach for most investors to participate in oil and gas is through an equity investment or a Direct Participation Project (DPP). A DPP is a non-traded pooled investment that works over several years and provides investors with access to the cash flow and tax benefits of an energy business. (Real estate DPPs, like oil and gas DPPs, operate in a similar manner and, like oil and gas DPPs, can engage in 1031 tax exchanges.)
A DPP is primarily used to fund the development of numerous wells in the oil and gas industry. The benefit to the investor in the first year is the tax write-off, which can be up to 85% of the investment. When the drilling is finished after about a year, investors begin to receive a monthly dividend. Depending on the success of the drilling, the returns can range from very low to very high. The first 15% of this income is tax-free, while the rest is regarded as ordinary income. (Consult a tax advisor.)
The well bundle is normally sold to a larger oil company after around 5 years. The proceeds from the sale are subsequently allocated proportionately among the investors, and the profits are taxed as capital gains.
Asset class diversification, great profit potential, and large tax advantages are all advantages of direct investments in oil and gas. Multi-well packages and skilled operators can help to limit risk to some extent. Investors, on the other hand, must be mindful of the drawbacks. Oil and gas ventures are inherently illiquid and speculative. Returns can be substantial, but they can also be non-existent. Oil prices have an impact on profitability. Furthermore, accredited investors are the only ones who can invest in DPPs.
Mineral Rights Leases
This is not an oil and gas investment, but rather a private financial agreement that works similarly to a real estate bridge loan. Investors are paid monthly cash flow based on contractually agreed-upon returns. The average investment time span is one to three years. Mineral rights leases demand lump sum payments to participate.
In this podcast with Kim Butler, “Investing in Mining Rights,” you’ll learn more about mineral rights leases.
Is Oil a Good Investment for You?
Do you have oil and gas in your portfolio? Direct investments in energy projects can provide significant and almost immediate tax benefits, as well as diversify investments and potentially increase returns. Oil and gas investments are worth considering as part of your overall plan because of these advantages.
For some, oil and gas may be a smart investment, but for others, it is not. There are requirements to be met, risks to be handled, and decisions to be made. The best investments in this field are only available to accredited investors. Some investors choose to put their money into greener options, while others are drawn to the oil and gas industry’s proven track record of earnings.
You might have other concerns about investing in oil and gas. We most likely know the answers! Partners for Prosperity focuses on wealth accumulation outside of the stock market. To learn more about hedging risk, boosting cash flow, and producing wealth that is not reliant on Wall Street dangers, schedule a complimentary appointment now!
In 2022, will oil prices rise?
Russia launched a new invasion of Ukraine on February 24, 2022, contributing to the recent steep rise in Brent and West Texas Intermediate (WTI) crude oil prices. The rapid spike in crude oil prices reflects increased geopolitical risk and uncertainty about the impact of recently announced and anticipated future sanctions on global energy markets. We raised our projected price of international benchmark Brent crude oil to $116 per barrel (b) for the second quarter of 2022 in our March 2022 Short-Term Energy Outlook (STEO), which was finalized on March 3. During the second quarter of 2022, we estimate gasoline prices to average around $4.10 per gallon (gal) and then fall for the rest of the year.
The price of WTI, the U.S. standard, is expected to average $113/b in March and $112/b in the second quarter of 2022, according to our prediction. Due to a number of circumstances, including Russia’s continued invasion of Ukraine, government-imposed restrictions on energy imports from Russia, Russian petroleum production, and global crude oil consumption, our projection is fraught with uncertainty.
Our forecast is more optimistic. The price of Brent crude oil has also increased our expectation for gasoline retail prices. We predict gasoline prices in the United States to average $4.00 per gallon this month, rise to a forecast high of $4.12 per gallon in May, and then gradually decline for the remainder of the year. We estimate that normal retail gasoline prices in the United States will average $3.79 per gallon in 2022 and $3.33 per gallon in 2023. If implemented, the average retail gasoline price in 2022 would be the highest since 2014, once inflation is factored in.
President Biden declared on March 8 that the United States would prohibit Russia from importing oil, liquefied natural gas, and coal. The United Kingdom has stated that it will phase out oil imports from Russia by 2022, while the European Union has stated that it will considerably limit the amount of fossil fuels imported from Russia by 2030. We finished our March STEO report before the US, the UK, and the European Union all announced new restrictions on Russian energy imports, thus our forecast does not factor in the impact of these statements on energy markets.
Furthermore, some multinational oil companies have indicated plans to cease operations in Russia and terminate relationships with Russian firms, potentially limiting future crude oil production in the country. The fresh pronouncements may increase upward pressure on crude oil prices; but, any international response and the implications of that response on global balances remain unknown.
When it comes to the expiration date, why do futures and spot prices converge?
Because the market will not allow the same commodity to trade at two different prices at the same time in the same place, convergence occurs.
Is the Federal Reserve buying futures?
Banks and fixed-income portfolio managers utilize Fed funds futures to protect themselves against short-term interest rate volatility. They’re also a popular way for traders to speculate on the Federal Reserve’s future monetary policies. The CME Group has developed a technique that analyzes fed funds futures contracts to calculate the likelihood of the Federal Reserve modifying monetary policy at a given meeting, which has proven to be valuable in financial reporting.
What impact do futures have on price?
Futures prices take into account supply and demand projections, as well as production levels, among other things. The cost of carry and interest rates are responsible for the difference between a commodity’s spot price and its futures price at any particular time.