The futures curve is not a price forecast

Futures prices are often used in the macroeconomic models built by central banks and other official agencies, and it is tempting to view them as a commodity price forecast. In the Bank of England’s latest monetary policy report (January 2020) it shows a chart of the crude oil and futures curve out through 2020. The BoE interpret the change in the oil futures curve as being slightly more inflationary in January 2020 than three months earlier, while the gas futures curve as being significantly less inflationary.

Uncertainty over the future price of energy is thought to be one of the main causes of uncertainty in inflation projections – complicating decisions over future monetary and fiscal policy. Work by the European Central Bank found that a 20% change in the oil price can affect inflation by approximately 0.4–0.8 percentage points (depending on the initial level of the oil price). Indeed, the chart on the left shows how important a driver energy prices have been to falling inflation in the UK.

This reliance on energy market futures curve to direct monetary policy is a mistake as its likely to underestimate inflationary pressures. To see why it’s important to understand what a commodity futures price actually represents.

To recap, futures markets provide a means for trading the price of a commodity for delivery at some point in the future. The shape of this series of prices is known as the futures curve. The notion that the futures price is the best forecast of the spot price comes from a belief in the so-called “Efficient Market Hypothesis”. In an efficient market, new information is instantly reflected in commodity prices.

The two terms “futures” and “forecast” both sound like they should represent the same thing. They are anything but. A cursory review of the futures curve’s behaviour in recent years shows that it has been a very poor predictor of realised spot commodity prices. The futures curve shows the price at which it is possible to buy or sell contracts for a date in the future at a price agreed on today. It is not a forecast of future spot prices.

A futures curve is described as being “in contango” when it is upward sloping and so prices in six months’ time are higher than the spot price. This is also known as a normal curve or a normal market. Traders will pay a premium to avoid the costs associated with transporting, storing and insuring a commodity (known as the cost to carry); so, the furthest-out contracts are typically higher in price. In contrast, when the shape of the futures price curve is downward sloping, then the market is said to be in backwardation. This is also called an inverted curve or an inverted market.

Forecasters may view a rising futures curve (a market in contango) as a sign that the market expects higher prices, and vice versa for a downward sloping futures curve. This is based on the perception that futures prices should incorporate all the available information to market participants, and that they also act as signals of what the “market” expects to happen.

There are several factors that affect the futures curve, not just market expectations of where the price of a commodity will be:

  • First, the physical characteristic of the commodity – whether it is easy to store and whether there are ample inventories, etc.
  • Second, longer dated contracts are illiquid, raising doubts of whether they are an effective aggregator of information. Given that monetary policy acts with a lag in excess of a year that raises doubts.
  • Third, the futures curve fails to account for inflation.
  • The fourth and final factor is that futures prices will always be discounted to the market’s expected future spot price in order to give investors a “risk premium” to take on risk from producer hedgers (known as the “normal backwardation” theory). This means that even if the spot price is estimated correctly, the traded futures price will tend to understate the market’s current real price expectations.

Despite all its faults forecasts by government institutions are likely to continue to use the futures curve. Why? It is because it is a simple and transparent market-based measure and so it is preferable to more opaque model-based forecasts.

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