Wednesday, October 31, 2007

Do exchange traded futures matter when there are also swaps and forwards?

In a word: yes. I wanted to post a follow up to a comment to my recent post “2015 Futures.” That comment argued, contrary to my own position, that the availability of crude oil futures out to 2015 didn’t substantially improve the ability of oil producers to ensure profitability of “expensive” oil ventures. Here it is:

Producers could fix their revenues out 5 yrs well before this listing. 1st, most large hedgers are likely to use calendar averaging swaps, not futures (which impose onerous variance margins, ie ongoing cashflow swings .) Swaps are cash settled against an index (typically NYMEX but often Platts) and are secured by an ISDA agreement and the balance sheets of the contarcting parties. Margin isn't assessed day to day so often it amounts to a long term loan.

The interbank market has quoted long dated swaps in these tenors for some time. Morgan Stanley and J. Aron are two of the larger market makers, but any highly rated investment bank would likely quote something out that far.

It is certainly true that swaps exist, and so do bilateral forward contracts for delivery which are arguably more important in this regard. The reason that exchange traded futures—negotiable instruments—are critical is that they alone most accurately fix the market price that is the basis of swaps and forwards. Any two parties can enter into a contract for delivery of oil at any point and for any point in the future. You can enter a binding contract to deliver oil for $10 a barrel in the year 2099 if you want. The value of an exchange-traded, negotiable instrument is that there is great volume, liquidity, and transparency (here on the NYMEX crude oil pit), and this sets the effective price. The comment above essentially concedes this point in stating that swaps are settled against an index, such as NYMEX. The ultimate point is that the availability of futures out to 2015 (8 years out) is significant because it acts to more effectively fix a value on oil at that distant time, and therefore makes any instrument to “lock in” that price—whether that is a future, swap, forward, etc.—more accurately to the extent that it can index against the value of the NYMEX future.

I should also point out that my choice of “Canadian Tar Sands” as an example was poor, as it is already being produced in significant quantities. I think that the 2015 futures remove one obstacle from producing more expensive tar sands reserves, but the far better example is Colorado oil shale. The oil shale deposits on the Western Slope of the Rockies have been, with some hyperbole, said to be the “Saudi Arabia of Oil Shale.” Well, with the NYMEX December 2015 crude oil contract currently trading at $80.92/barrel (on 619 contracts volume), where are the Colorado oil shale projects??

Well, in a timely enough manner, CNN has an article out yesterday claiming that "Oil Shale May Finally Have its Moment." They claim that Shell is nearing the ability to use a secret new technology to produce oil from kerogen in an economical manner. The article suggests that Shell has been working on this technology for years, and that they may be profitable at $30/barrel oil. Critically, they don't mention when that $30/barrel profitability estimate was made. Princeton Professor and peak oil scholar Kenneth Deffeyes commented in "Beyond Oil: A View from Hubbert's Peak" that "When oil was $3 per barrel, many people said that if oil ever reached $8 per barrel, Green River oil shale would have its revenge on Spindletop and shut down the oil industry." Hmmm... sounds like there may be a sliding scale at work here. Why? Well, the crux of Shell's "secret" technology is to insert probes into the kerogen and heat it over a long period of time, and to surround those heater probes with freezer probes that trap the liquefied kerogen within an ice shield. Sounds energy intensive, doesn't it? If it was an energy-positive process at $8 a barrel when the energy used cost $3 a barrel, and it was energy positive at $30 a barrel when the energy used cost $15 a barrel, it doesn't sound too promising to me. Surely Shell has made improvements, but even IF they get the EROEI of the process all the way up to 1:1, or even 3:1, that is nowhere near the EROEI of our current, depleting sources of energy.

Technology under development in a laboratory is great. Show me the projects.


Ryan said...

Do you remember Joan C.? Her husband, Travis worked for Shell, and he used to talk about how they bought out patents on all these alternate technologies and just sit on them to keep them out of the market. I suspect we'll see them when the price has been sufficiently driven up. Good talking to you yesterday.

Rice Farmer said...

You're not the only one to express reservations about this. Well, of course it's technically possible, and improvements will be made. Nevertheless, the bottom line is defined by the EROEI, which translates into price. Will it produce oil at a price low enough to prop up what conventional oil has built? Further, will environmental remediation costs be factored into the price? To hold down the price, I suspect that there will be little or no environmental remediation.

clifford.wirth said...

Oil shale will never yield a drop of net oil for the U.S. Walter Youngquist of the Colorado School of Mines provides a detailed history and analysis of Colorado’s oil shale. After spending billions of dollars, industry has terminated oil shale operations due to a low net energy recovery and a lack of necessary water resources.

Alternatives for replacing oil will not yield much. See my full report at

Anonymous said...

The value of an exchange-traded, negotiable instrument is that there is great volume, liquidity, and transparency (here on the NYMEX crude oil pit), and this sets the effective price

The thing is, NYMEX futures don't set the swap value now, only at maturity. What sets the swap value now are the market making institutions like investment banks capable of warehousing the commodity price risk and credit exposure entailed by such long term positions. The futures settlement farther out will follow the OTC indications, not the other way around.

Take a look at the open interest for the Dec 2015 contract: 7000 lots, versus 400,000 in the prompt. A paltry daily turnover of approximately 50 contracts (less than the minimum tradable volume in the OTC market.)

A far better indication than NYMEX out that far is found on the more OTC-oriented ICE exchange where NYMEX Platts and Brent indices all inform the prices.

Keep in mind also that most of these things are traded on a screen now anyway, including most NYMEX futures contracts. The futures pits are practically empty. Beyond the NYMEX suffers also from its physical delivery point: Cushing this year essentially decoupled from the rest of the world when its takeaway capacity was maxed out.

A better index for US prices in the Gulf Coast is the Platts LLS index (louisiana light sweet) -- swaps on this trade pretty heavily on ICE and the otc brokered market.

Anonymous said...

more on the Cushing/WTI bottlencek issue plaguing the NYMEX. Another distorting factor used to be fund rolls that kept the futures prices in an artificial contango. That's gone away with new flexible commodity indexes like JP Morgan's.

The EROIE analysis misses something very important: the feedstock price and transportation characteristics. Is the energy input coal, hydro or nuclear? What is the dollar cost per MMBTU? Why is the "net energy input" involved in synthesizing fuel for transportation important if there are no cars (yet!) capable of burning coal? If it cost 5 MMBtus of coal to generate 4 MMBTus of gasoline, it may still make perfect sense, if coal costs $2/MMBTU and gasoline costs $30. the only thing that matters is the dollar return, which is entirely driven by the fuel's usefulness.

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