Long Term Contracts

At Marginal Revolution, Tyler Cowen speculates on the reasons for the absence of long-dated futures contracts on the oil price. There are several reasons for this absence.

First, note that corporations do not have an incentive to hedge far forward exposures. A manufacturer knows that his company will be a net buyer of energy for the foreseeable future, and can estimate the size of his demand, which might theoretically permit him to hedge. But if he does so, and his competitors do not, he is greatly increasing his company's risk. This happens because, in case of a rise in energy prices, his cost of production will rise, as will his competitors'. Since they are all in the same boat, they will pass the increased cost to their consumers. There may be some second-order effects (increased price lowering demand and leading to oversupply), but they are much smaller than the total forward energy price exposure. A CFO who hedges his energy needs will make a windfall profit if prices rise, and a similar loss if they fall, thus introducing extra volatility into his company's stock price, to the annoyance of investors. The market demands that such users follow the herd.

[While it sounds unflattering, this is in fact a desirable outcome from the investor's point of view. It makes it much easier for an investor to know what he is getting when he buys the manufacturer's stock.]

Liquidity is often supplied by proprietary traders and hedge funds. However, this liquidity never serves to extend the forward curve to longer maturities. The main reason is that hedge funds must show results to their investors relatively frequently, and may be obligated to unwind their positions if investors withdraw money. The result is that hedge funds fear illiquidity more than anything else. They cannot hold long-dated contracts until maturity, and cannot rely on unwinding them in midstream; so they will never take positions actively enough to provide liquidity. The same reasoning applies to proprietary investors at banks and pension funds.

Some hedge funds demand a "lock-in period" from their investors, requiring a year's notice or more for withdrawals. They could in theory buy to hold, but it is unusual; more often they are investing in intrinsically illiquid markets like Chinese real estate. A fund taking this disadvantage on itself in the competition for investor dollars is most likely to use the resulting cash in markets where normal funds dare not enter.

Finally, market professionals are much less overconfident than pundits. It is fine for Kevin Drum
to bid oil forward at 30% above the market price; but even the most junior trader would be disciplined for such a boneheaded move. Motivated by pragmatic calculation, not ideology, these people realize that there is a 45-50% chance of being wrong, and that success requires both being right and executing efficiently with minimal risk. Trading on expectations of a far future event, like the price of oil in 2010, introduces tremendous uncertainty, and those arrogant enough to imagine they can predict it precisely do not survive long enough to try. There are off-exchange markets on WTI forwards among the large dealers and investment banks, but the bid-offer spreads are very wide (commensurate with the uncertainty) and trades are infrequent. This situation is very stable.