Calling oil wrong

Chart of the day - from John Kemp at Sempra Metals:

Here’s an illustration of how the market has consistently called the future price of oil wrong over the past five years - snapshots of forward prices each November, compared with the reality of crude prices. Since 2003 the forward market has persistently ignored the great oil rally.

So if the market has failed to signal real future prices in the recent past, why should we believe that current market indications will prove more accurate?

It’s an important question - especially when policymakers seem to be citing the curve in forward prices as a signal that oil prices will stabilise in the near-term, taking the heat out of inflation, while hard-boiled oil bulls also use the charts to back predictions that crude will remain above $100 for the next decade.

All of which gets right under the skin of Mr Kemp:

The forward curve does not tell you anything about future realised spot prices AND IT DOES NOT PURPORT TO.

He says there is systematic confusion about what forward prices mean.

The forward curve shows you how much you pay to buy crude oil (or any other commodity) at a future date with a price fixed today. It does not show you how much the market thinks that the commodity will actually cost when that future date arrives. There are a whole variety of premiums and discounts built into the futures prices (including cost of carry, convenience yield, investor premium/normal backwardation, and liquidity) that can cause futures prices to diverge substantially from the market’s best guess of the future spot price (and this is unobservable). Because the premiums/discounts are not static, you cannot back the expected future spot price out from the futures prices.

So, to be clear, the forward price is NOT the market’s collective best forecast for the future spot price.

This is a simple point (well understood as long ago as the 1930s by John Maynard Keynes) but which appears to have been unlearned by much of the investment and policymaking communities in recent years.