Crude Oil Prices

Crude oil prices have been tanking recently with the stock market and other commodities.  I just thought I'd mention an interesting thing about crude oil prices which might have some relevance for people looking at oil company stocks and oil price ETFs.

The November 2011 contract for WTI crude closed today at $77.12, quite a drop from the $90-100 level we've been getting used to recently.

However, if you price oil company stocks based on this price, it might be a little misleading. 

Stock prices should be evaluated based on longer term price levels, not on what the near-month futures contract is trading at.

What do I mean?

The December 2019 futures contract closed today at $88.69/barrel, or close to $90.  This is a more 'normal' estimate of what crude oil prices will be valued at over the longer term.  In that sense, the supply/demand imbalance that experts expect is still intact.

Near-month or front-month contract prices reflect more immediate needs (due to close expiration/maturity) and speculative interest (due to high liquidity). When there is a current shortage of a commodity, it trades in 'backwardation' (Front month trades higher than back month contracts).

This backwardation in the past is why commodity ETFs had such wonderful looking historical track records.  In backwardation, every time you sell the front month near expiration and buy the next month out, you earned a positive spread.  Keep doing that in a backward market and you make money even when the underlying commodity is flat.

Recently, however, crude has been in contango (front month cheaper than outer month), so every time the futures contracts are 'rolled' (front month sold and rolled into the next contract month) they end up selling something for less than what they have to buy next.  This causes a loss every time the contracts are rolled even in a flat underlying market.

Anyway, here is what the crude oil curve looks like:

Nov 2011 contract:  $77.21
Dec 2012:                $80.46
Dec 2013:                $82.69
Dec 2014:                $83.83
Dec 2015:                $84.99
Dec 2016:                $85.17
Dec 2017:                $86.48
Dec 2018:                $87.71
Dec 2019:                $88.69

For crude oil linked ETFs and other products, it's OK to use them for short term speculation, but if you are intending to own them over time, make sure you understand that in certain market situations, you can lose money even if crude oil prices don't move too much.

For evaluation crude oil companies too, understand that front-month oil volatitility may not necessarily reflect what oil prices are expected to be over time.  For that, sometimes further out contract months are a better indication.