Hi David,
I have been having issues understanding the normal/inverted and contango/normal backwardation theories related to the futures pricing. Please let me know if my understanding is correct:
Today's date - T1
I am an oil producer and want to sell my oil in the market 6 months forward. In order to hedge my exposure I am likely to either go short on futures or wait for the spot prices 6 months forward.
I will have to store the oil for 6 months and hence incur costs if I choose to sell in the cash market. Hence, I will look into the 6 month futures price and see if I can lock in a higher price in order to avoid the storage costs. As of today, I can only know that probably due to winters in 6 months, there will be huge demand for oil and hence higher price. This would translate into a higher futures price. Right? Also since I would be incurring the storage costs, I need to be compensated for that as well. Hence considering these two factors my futures price and spot price would be higher going 6 months forward.
At the end of 6 months, the futures price that we have been talking about should essentially be the spot price at time T2 since we locked in a price which we think should be the expected spot price on T2? Then why do we again say that the futures price at Time T2 is different from the one we entered at T1? If the underlying asset hedged and the contract have identical assets then there should be no difference in the spot price and futures price at T2 ( which leads to a basis of 0), only when the assets are different there can be a difference. This difference too should be the difference in the spot price of the two assets technically.
Hence when we calculate the gain at T2 we take the difference between the futures price and spot, we find the spot price is lower than the futures. Is it because of the market being in contango due to which it started converging to the spot price, and as a result the resulting spot/futures price is less than the delivery price? which leads to a gain to the producer who is shorting the contract? But in the scenario that there would have been supply demand issues and the market would have shown a mixture of contango and normal backwardation, the converged futures and spot price end up higher than the delivery price - thus posting a loss to the person shorting the contract?
If you could explain the discrepancies..would be great
I have been having issues understanding the normal/inverted and contango/normal backwardation theories related to the futures pricing. Please let me know if my understanding is correct:
Today's date - T1
I am an oil producer and want to sell my oil in the market 6 months forward. In order to hedge my exposure I am likely to either go short on futures or wait for the spot prices 6 months forward.
I will have to store the oil for 6 months and hence incur costs if I choose to sell in the cash market. Hence, I will look into the 6 month futures price and see if I can lock in a higher price in order to avoid the storage costs. As of today, I can only know that probably due to winters in 6 months, there will be huge demand for oil and hence higher price. This would translate into a higher futures price. Right? Also since I would be incurring the storage costs, I need to be compensated for that as well. Hence considering these two factors my futures price and spot price would be higher going 6 months forward.
At the end of 6 months, the futures price that we have been talking about should essentially be the spot price at time T2 since we locked in a price which we think should be the expected spot price on T2? Then why do we again say that the futures price at Time T2 is different from the one we entered at T1? If the underlying asset hedged and the contract have identical assets then there should be no difference in the spot price and futures price at T2 ( which leads to a basis of 0), only when the assets are different there can be a difference. This difference too should be the difference in the spot price of the two assets technically.
Hence when we calculate the gain at T2 we take the difference between the futures price and spot, we find the spot price is lower than the futures. Is it because of the market being in contango due to which it started converging to the spot price, and as a result the resulting spot/futures price is less than the delivery price? which leads to a gain to the producer who is shorting the contract? But in the scenario that there would have been supply demand issues and the market would have shown a mixture of contango and normal backwardation, the converged futures and spot price end up higher than the delivery price - thus posting a loss to the person shorting the contract?
If you could explain the discrepancies..would be great
