John Tierney is looking to bet that oil prices will fall. He can find some willing opponents here, and they will offer him the best odds available. I’ve been urging Alex to short real estate investment trusts; if he has already done so I fear for his ruin. Brad DeLong discusses Google. Jane Galt warns against such bets, on the grounds that timing is everything and no one knows when the bubble will burst.
It remains an open question why markets don’t sell long-term bets for those people who have "price knowledge" but not "timing knowledge." The longest-term NYMEX crude oil futures sell for 84 months ahead; admittedly a forward contract can stretch longer. But why can’t you make a 30-year bet on organized markets? I see a few hypotheses:
1. There are few if any people who have real price knowledge but not timing knowledge.
2. The disagreement in the market is about timing, so shorter-term contracts attract the attention and volume. You might disagree about whether something will happen this month or next, but you can’t argue about whether it will happen ten or eleven years from now.
3. Long-term contracts make economic sense and someday we will have them. Right now we are out of equilibrium. We await tolerant regulators and heroic entrepreneurs.
4. You can replicate long-term contracts by trading short-term contracts in successive fashion. The informed traders have enough liquidity and borrowing power to make this work. (But hey, if that is so easy, why not have even fewer oil futures contracts?)
5. Liquidity is scarce, and involves significant economies of concentration. Intermediaries limit the number of contracts, just as we have limited trading locales and trading hours. (Admittedly many of these limits have, for better or worse, broken down.) Remember when the French used to trade stocks just a few times a day?
Take your pick or add to the list. Unless you opt heavily for #3, the market is saying that a general knowledge of price — without a knowledge of timing — simply isn’t worth that much.
My bet on oil prices will be restricted to buying another economy car, next time around. It is better to spend the money on books anyway, no?
Thanks to Tim Bartlett for the pointer.
The oil market reminds me a bit of the gold market in the late 1970s. Amid
predictions of $1000 gold and a coming economic apocalypse, the yellow metal
topped out at about $850 in January 1980, then began a long decline.
World oil demand is growing at 3.5-4% annually, even with China’s 7% growth.
Assuming it grows at 4% it would take 18 years to merely double. How does
that translate into $200 oil in 2010 for an average price without a large
fall in it supply?
With the Dec. ’10 contract under $64, $200 oil seems like a real sucker’s
bet.
In the meantime, you can read Thomas Gold on _The Deep Hot Biosphere_ and
Peter Huber and Mark Mills on _The Bottomless Well_.
Hypothesis (4) is, I fear, wrong; this was spectacularly demonstrated by Metallgesellschaft AG in 1994.
More generally, rolling short contracts only works when the cost of carry (convenience yield of commodities) is deterministic. This is a reasonable approximation for stocks, but completely off the mark for oil.
Could it be that the probability of short-term fluxuations near the maturity date of long term contracts increase the risk of such contracts beyond acceptable limits for most potential traders?
A “bundled” contract for a certain amount of oil once a week for a year ten years from now could have a much more certain long-term value than a contract for all of the oil on the same day.
Having said that, a ten-year contract on oil, of any form, is much more a bet on policy and politics than anything else. What are the odds that nine years from now Iraq and Iran have a policy interaction (war or merger) which affects prices? Egypt and Saudi Arabia? What are the odds that the US engages in an agressive policy of building nukes or of exploitation of domestic oil sources currently held off-limits? What are the odds that the US falls into a period of significant inflation? What are the odds of a global recession?
I think that the lack of long-term contracts on oil reflects a fundamental volatility which is both of high magnitude and low frequency.
How about “most people really don’t focus much on the long term?”
Anyway, I don’t see how a long term contract can work. If you use leverage, it can’t really be “long term” if fluctuations in price make premature margin calls likely. If you don’t use leverage, only radical predictions can have an expected return better than that of the market.
Long term uncertainty about nominal variables is certainly important.
I think that much finance silliness goes away if one reformulates the relationship between wealth and utility as a relationship between log wealth and utility. Doing so certainly clarifies the problems with leveraged financial strategies.
“the yellow metal topped out at about $850 in January 1980, then began a long decline.”
I bought our wedding rings in January 1980. We celebrated our 25th anniversary this past April with our 3 children (23, 20 and 18) and numerous friends. The rings were cheap.
Mr Tierney got the odds much better than anything he would find on the futures/options market, by my rough estimates about 100 times better. Some rudimentary hedging would make his bet the best investment in his life.
Price knowledge without timing knowledge is, basically, useless. I can bet any amount at any odds that the price of any given commodity will be $1234 at some point in time in the future. I will never have to pay anything and there is some chance of winning – if the price gets there during my lifetime. A bet, anyone? You can pick the commodity, the odds, and the level as long as your bet is at least $100
30year futures contracts do not solve the problem: if am not sure about timing, can I be sure that the price will not climb to the desired level in 20 years time and then slide back?
Infinite maturity american-style options are appearing on the market, but their price is too sensitive to the carry cost and volatility.
So my guess is that long-term markets do not exist for a number of reasons mentioned in other comments, but even if they would exist they would not solve the problem you are discussing.
What is really odd is that the futures market prices range between $66 and $69/barrel, and yet a recent Reuters poll of analysts yielded and an average forecast of only a shade over $50/barrel. See here:
http://the-econoclast.blogspot.com/2005_08_21_the-econoclast_archive.html#112508617561303808
Keynes already has your answer: in the long run, we’re all dead.
Review your black-scholes: the value of an American option is unbounded in time. Put differently, the random walk underlying the derivation of the pricing formula means any price will be traversed with probability approaching one as time goes to infinity. Since participants in security markets must work with finite quantities of capital, that one obersvation reveals tradable options will have a natural “maximum term.”
But it’s worse than that. The actual distributions underlying real securities are much heavier-tailed than the log-normal distribution used for the canonical black-scholes closed form solution. Also, options holders bear counter-party risk. Your investment bank or Options Clearing Corp maybe be solvent today, but twenty years hence? Both of these effects increase volatility, loosely speaking, and shorten still further the natural maximum term for a widely tradeable option.
That said, I will sell you any option you want, put or call, on any underlying thing you care to dream up, provided you meet two assumptions:
(1) It’s a European Option. No early exercise allowed.
(2) The expiration date is after the year 2100
1. Eclectic Econoclast, there is no reason why analysts consensus should match the market. They are analysts, not traders, after all.
2. Patinator, it is rather unusual to price calls and puts with the same strike at different volatilities. It is arbitrageable.
3. tylerh, the value of an American call option on a futures is upper bounded by the futures price. Hence, it is not unbounded when the futures price isn’t.
The problem with such long term contracts is that price discovery becomes too difficult given the risk of the contract. Traders, clearly uncertain about economic conditions 30 years in the future, will make the bid/ask spread so wide on any long-term contract that the profitability of trading such contracts becomes nonexistent.
Patinator – using such dramatically different volatilities for calls and puts makes no sense from a trading standpoint. Given your prices, I could sell your 30 year call and buy the corresponding put, making me synthetically short a $66 crude contract for a credit of $15.07. I buy futures to hedge my position, giving me no risk to price fluxuations. The cost of carry on the futures contract over 30 years is fairly low, given that a professional futures trader can easily obtain 10% margin rates, as well as cross-margining the price movement risk against the options position, which means as long as I keep my option position on, I’ll never suffer a margin call. By hedging interest rate risk with long term bond contracts, I look to make about $9 per contract on a considerably lower investment, perhaps as low as $3 total given institutional rates. That’s a healthy 10% annualized investment with far less risk than the stock market.
mic & Jason – Point taken about the volatilities. I didn’t input them, they were just input defaults for oil on my Bloomberg Option Valuation screen. Today, the call and put volatilites are just about the same and the arbitrageable mistakes are gone. I did think it odd when I saw it but am not an oil expert and trusted the historical volatilites from Bloomberg.
bjr – On the 30 year contracts in my calculations, time value was 99% of the price.
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