Oil Prices: What the Futures Market Sees

It may be a better indicator of upcoming prices, says a government study. The verdict now? Petroleum is headed higher

by Peter Coy

Just when you thought oil prices were getting under control, they've shot back up, closing on Feb. 1 at more than $57 a barrel after briefly dropping below $50 just two weeks earlier. Now, more bad news. A study by four government economists says more attention should be paid to a long-standing but little-heeded indicator of where oil prices are headed—namely, the futures market. And that indicator—imperfect as it is—says prices are likely to rise a little past $60 a barrel and then stay in that range for years to come.

A draft of the unreleased study was provided to BusinessWeek.com by its authors, who work for the Commodity Futures Trading Commission. It represents the views of the CFTC staff, but not necessarily the commissioners. The authors plan to release the study to the public within the next week, by posting it on the CFTC Web site.

The staff study focuses on a crucial question: Where are oil prices headed in the long run? Geologists, economists, oil company executives, and others are deeply divided. Some experts predict that prices will soon rise to $200 a barrel as worldwide production tops out and begins to fall, while others say oil could fall to $20 or less because of a glut from overproduction. While no one knows for sure, and futures prices have a history of swinging wildly, it's also true that commodity markets represent the collective judgment of many smart people who have their own money at stake.

Thirsting for an Accuracy

Crude price moves created big winners and losers in Corporate America in 2006. Exxon Mobil (XOM) announced on Feb. 1 that it earned $39.5 billion in profits last year. That was the most profit of any company ever, even though the late-year dip in crude caused profits to fall in the fourth quarter. Royal Dutch Shell (RDS) reported a $25.6 billion annual profit. On the other hand, high oil prices hurt the popularity of sport-utility vehicles and pickup trucks, creaming companies like Ford Motor (F), which lost $12.7 billion in 2006, its biggest loss ever. Ford Chief Executive Alan Mulally said the company is moving towards more fuel-efficient vehicles: "We fully recognize our business reality and are dealing with it."

Ford would have lost much less money in 2006, or even made a profit, if its long-term forecast for gasoline prices had been more accurate. Others that are thirsty for an accurate forecast are alternative-energy companies, which will lose money if oil gets too cheap and makes their products uncompetitive. For that reason, James Overdahl, the CFTC chief economist, says he has been approached by the International Monetary Fund and others asking what governments could do to encourage the development of active trading in longer-dated futures. Now, says Overdahl, "It's happening in some ways on its own."

The CFTC study focuses on the New York Mercantile Exchange in crude—oil futures—that is, contracts to buy or sell oil at a set price at a certain time in the future. Many traders use Nymex prices as a gauge of the world's expectations of where oil prices are headed. For years, nearly all of the trading in that market was in short- or medium-term futures. There was so little trading action in oil for delivery more than three years in the futures that the market was unreliable and largely neglected. A single big trade could move the price up or down significantly because the market was so thin.

Link to Oil Swaps Market

But the futures market has matured since 2000, the number of open long-term contracts has shot up, and the prices of long-dated futures are being viewed by market participants as a more reliable indicator of where oil prices are headed, says the CFTC study, authored by Michael Haigh, associate chief economist; Jeffrey Harris, consulting economist and a professor at University of Delaware; Overdahl; and Michel Robe, consulting economist and a professor at American University.