Activity when futures are tangled

Quantitative Finance Level 1

If the oil future is in contango, which of the following activities are we most likely to observe?

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Oil fracking will increase Gas / Petrol prices will rise Offshore drilling will increase More offshore oil tankers will be rented Oil spot price will increase

1 solution

Chew-Seong Cheong
Feb 25, 2015

When the oil futures is in contango, a contract to buy crude oil in the future costs more than the current price. The further into the future, the higher the price. Therefore, it is worthwhile to traders to rent more offshore oil tankers to store the crude oil.

The expected future cost should be $F = Se^{rt} +$ various carrying costs. So in general, the future would be priced higher than the current spot price, to take into account interest and inventory.

Note that contango means "the price of an oil future is more then the expected cost of the oil in future". When future prices on the electronic markets are (significantly) out of line, we will start to see the physical markets due to arbitrage activities. For example, more of the current oil production will be stored in tankers (which are cheaper than on-shore storage), so that it could be sold in the future to be more profitable (even after the carrying costs)

Calvin Lin Staff - 6 years, 3 months ago

If I get it right, that something is in contango means that there is an opportunity of getting a profit if I buy it now, store it (provided it is not perishable), eventually transport it (or not), and then sell it in a future time, because the price in the moment of selling will be higher than the natural increase due to time value plus storing and (eventually) transport. Right?

If right, who decides that something is in contango? Is it a subjective perception of the possible buyer (because he knows some circumstances will come into play in the meantime)?

Félix Pérez Haoñie - 1 year, 7 months ago

Is it not true that gas prices will rise as well?

A. Daniel - 3 years, 8 months ago

Not necessarily. For example, there might be a supply glut in June that causes the spot price to fall.

Calvin Lin Staff - 3 years, 8 months ago

Wtf? I literally didn't even understand what the question was asking. There was no education, just a butt load of assumption that we would know what these esoteric terms mean and how to apply it to determining the answer. I came here to learn about the more confusing aspects of finance and find myself even more annoyed and frustrated. Who vetted this?

Karl Weimar - 1 year, 9 months ago

Hello Karl,

I'm sorry for the confusion. This problem is meant to be read in the context of the following wiki page: https://brilliant.org/wiki/pricing-forward-and-futures/

This wiki page gives the context for futures pricing and the meaning of "contango".

If you ever have any confusion about the terms used in a problem, our search feature will allow you to find wikis for more information.

Andrew Hayes Staff - 1 year, 9 months ago

^ Just learned something

Mike T - 1 year, 5 months ago

I didn't know what "contango" meant either!

Deborah Bharucha - 9 months, 2 weeks ago

Did you view the wiki page?

Sometimes you may not have all of the information necessary to solve a problem (whether that's because you don't know a term, or don't know of a technique). If so, do so research to learn more about them. The courses / wiki pages are a good place to start.

Calvin Lin Staff - 9 months, 1 week ago

Activity when futures are tangled

Image credit: Wikipedia Suicip

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