When Headlines Are Wild, Look to the Markets for Answers
When the headlines seem outlandish, it helps to find other sources of information. The media coverage of the recent price of oil offers a perfect example.
I was driving home recently when I heard a crying woman being interviewed on the radio. She was justifiably upset, because she had just spent $17 for three and a half gallons of gas. A trucker was quoted on the same news show as having paid $725 to fill his rig with diesel. He said he had to fill up every two days.
Meanwhile, the headlines were predicting oil prices climbing to $200-$300 per barrel.
Moreover, with the situation in Ukraine remaining highly unpredictable, the mainstream consensus is that there is no hope of lower prices in the energy markets anytime soon. This view may prove correct.
That is, of course, if you ignore what the futures markets are saying, at least for the moment.
I’m as concerned as anyone by the pain being inflicted on that poor lady, and others like her, by higher gasoline prices. I have a daily 60 mile round trip.
However, part of my job is to sort out what the markets are telling us. With this article, I’ll help you make better sense of this situation, and perhaps deliver a glimmer of hope for the future.
The organized futures markets were created in 1697 by rice farmers in Japan with the first real exchange opening in 1730. These markets were created to allow farmers to manage risk for their crops in case of bad weather or other problems which could develop by the time harvest arrived.
Conceptually, little has changed. Today, the main function of futures markets remains that of providing companies who produce commodities with a vehicle through which they can hedge risk. Their secondary function is to provide a vehicle for speculation for investors.
The futures market works in tandem with the spot market, markets that trade in the present. Futures markets are essentially like the spot market but at some point in the future.
Here’s a simple way to understand how all this works.
For example, if in January, a trucking company CEO is concerned about the availability of fuel for the summer, he may instruct his trading department or his broker to buy July gasoline futures. If the price falls between now and then, he wins because he gets less expensive fuel delivered, although he may face a trading loss. If the price gains, he also wins because he may wish to sell the futures contract for a profit, while buying fuel in the spot market, thus cutting his operating costs.
What’s in a Price Point?
This is a simple, but often ignored concept, especially for stock traders who are used to the stories that often go into marketing stocks, such as whether a company’s CEO is truly a genius. Think Tesla (NSDQ: TSLA).
Indeed, unlike stock prices, futures prices are actually based on the status of supply and demand for the underlying commodity. Moreover, contrary to the widely held view, it’s actually the status of supply that drives futures prices more so than demand.
In other words, when prices rise in commodities, it’s more a result of the markets expecting a decrease in supply. You can see that in grain prices where a great crop will decrease the price of wheat for a season.
In this case, the market has been betting that the global oil supply will decrease because of the war in Ukraine, and thus prices have been rising.
However, as I will show you in the next section, futures markets are excellent at figuring out how long any supply crunch may actually last.
Thinking Strategically and Sorting Out Trading Lingo
Of course, most of us don’t trade futures. And for good reason, because 90% of all futures traders lose money. The price volatility in those markets can be hazardous even to those with experience and big bucks.
But what the rest of us can do is to understand how these markets work and use the information that they provide to manage our own finances.
Let’s get our bearings with some market jargon.
When the price of a futures contract is higher than the spot price, it is known as contango. The reverse occurs when spot prices are higher than futures prices. This is known as backwardation.
In the following chart, crude oil prices are showing a backwardation pattern.
Certainly, the lingo can be confusing, but what’s important is the message. The table above shows a market that is in backwardation as of March 11, 2022, because spot prices were above the sequential futures prices.
The futures markets often give us a way to see what may lie ahead. When we have an idea about what could be lurking in the future, we may be able to plan accordingly. In this case the futures markers were correct, as the price charts based on data from 3/15/22 below clearly show.
The Oil and Gasoline Market, Today and Tomorrow
With crude oil recently trading as high as $130 per barrel barrel and Reformulated Blendstock for Oxygenate Blending (RBOB) Gasoline futures and gasoline at the pump at $4 plus, it’s hard to be bullish about personal finance unless you bought futures contracts in these commodities in December 2021.
But if you look at the crude oil contract for July 2022 above, you note that the price is at $98. Moreover, July gasoline was at $3.03 on 3/11. As I write, July gasoline is trading at $2.87.
Moreover, a look at the price chart for West Texas Intermediate Crude Oil spot price (WTIC) shows that the price of crude actually topped out in early March. Now, a sustained break below $100 could well take the price to $89 or so. A similar picture is visible with the price of gasoline:
Of course, there will be geographic variations due to taxes and other individual costs, which affect the price. And yes, things may change drastically for many reasons between now and July. But the point is that there is more to information gathering than mere headlines.
The relationship between the spot price of commodities and the price of futures contracts is a central concept in a free market economy. Because these markets are reflections of the supply and demand for commodities at any one time, and companies and investors rely on these relationships for financial gain and protection, they are a reliable gauge of where prices may stand in the present or in the future at any one time.
Certainly, there are no guarantees. But market-based data can be a useful adjunct to daily life. While there is pain at the pump today, if the futures markets are correct, by the summer, things may be better.
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