Friday, August 13, 2004

It's generally agreed that the current high oil prices are the result of an accumulation of factors, none of which by itself would be sufficient to drive prices up very far, or for very long. When combined, however, they have taken us to sustained record nominal prices and real prices that are high enough to constitute a significant drag on the global economy. This thoughtful article in today's New York Times reminds us that, while this is true, the magnitude of the outcome is also a function of decades of underinvestment in infrastructure that erased the former surplus capacity, which acted as the buffer against such glitches.

The article also touches on the role that the market feature called "backwardation" has played in this drama. Backwardation is a condition of commodities markets in which the price of the commodity falls off into the future months, the further you get from the nearest, or "prompt" month being traded. In equilibrium, the level of backwardation, that is, the difference in prices between successive months, should be just enough to cover the cost of holding the commodity in storage for a month, plus time value of money.

In practice, that difference varies a good deal, and is the subject of much speculative trading, as players bet on its widening or narrowing. Sometimes the difference goes negative, producing "contango", the opposite of backwardation.

But when you get beyond a year or two in the future, the shape of the futures market curve should flatten, because the alternate supply is not oil in a tank, but oil in the ground, the carrying costs of which are very low. This is at the heart of Mr. Norris's argument. When today's price for the commodity several years from now is very much lower than the price for current delivery, because the market believes that prices will fall back after the current crisis is resolved, it sends a negative signal to producers: investing to get more oil out of the ground will not yield an attractive return. This same feature has played Hobb with the value of oil company equities, which haven't benefited nearly as much as they should have from the runup in oil and gas prices in the last year. That's yet another negative signal for investors.

The good news is that the future price is rising, even though it is still well below the prompt price, signaling a belief that today's problems may persist for a while. That should finally result in an uptick in capital spending, which is the only way that world oil production is going to keep pace with the growth in demand; it has to look like an attractive proposition for investors.

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