Okay here is what might seem like a really dumb questions I have…
In the example 9 of CFAI text book 5, page 54, question 3 asks why the situation of oil spot price being higher than oil future price might exist. And the solution to this question points to the oil producers real option. Here is the solution:
“Oil producers hold valuable real options to produce or not to produce. They may not exercise this option unless spot prices begin to rise. Production may occur only if futures prices are below the current spot price, which is associated with a downward-sloping term structure of futures prices.”
My question is - Why would oil producers only produce when the futures price is lower than the spot price? Wouldn’t this imply a bleak outlook on the price in the future? I am not sure how this “real option” concept is related to backwardation.
Future price < Spot price - classic definition of Backwardation.
If someone bought a futures contract from you - at the maturity of the contract - they would exercise the contract - at the futures price (get oil at the lower contracted price) - and then sell the oil around at the spot price (which is higher) - make a profit there. But the oil producer also gains at that time - since the oil is being bought from them.
Spot price rising is an incentive for the oil producer to keep producing. The futures contract price being lower than the spot also ensures that the process keeps on going for a longer time.
Oil in the ground is an asset just like oil just produced is. Oil just produced or planned to be produced will be sold on spot market at spot price, while oil in the ground will be sold against futures contracts at futures prices. In a free market price pressures dictated by supply and demand for various contracts should setting the prices along the futures curve
since producers have the real option of producing more oil now or delaying production to any future month, they will choose to exercise this right whenever it’s profitable to them in their estimation, which of course would be cued by the futures curve of prices, if the futures price is lower then more oil will be produced now to take advantage of higher spot, while if the futures price is higher more future delivery contracts will be written to take advantage of higher prices in the future. This latter case may be due to a glut of oil inventories driving down prices in spot
