Sunday, February 15, 2009

Crude oil is getting cheaper — so why isn't gas?

Basis risk is something that many do not understand at first. That should change with this example!

From Yahoo: Crude oil is getting cheaper — so why isn't gas?: "
"Right now, in an unusual market trend, West Texas crude is selling for much less than inferior grades of crude from other places around the world. A severe economic downturn has left U.S. storage facilities brimming with it, sending prices for the premium crude to five-year lows.

But it is the overseas crude that goes into most of the gas made in the United States. So prices at the pump will probably keep going up no matter what happens to the benchmark price of crude oil."

Suppose you were hedging gas prices using West Texas Crude futures. The fact that the two prices do not move in unison is what we call basis risk.


Todd M said...

One also has to consider supply and demand. By this I mean demand for gasoline by the consumer and supply of WTI in Cushing, OK. The tanks in Cushing, OK are overflowing at the moment. Investment banks and oil traders are doing their best to secure tankers for storage so that they can take advantage of the steep contango. This problem is exacerbated when contracts roll. Imagine you are long March WTI crude and you are faced with delivery or rolling your contract. Where exactly would you store that crude? Wouldn't the high demand for storage drive up prices? So you sell your near term contract, depressing the front end of the curve and buy the contract three months out. Also one might want to look at market power exerted by the large refiners vis a vis the consumer. Are they running at full capacity or 80% of capacity? Is it reasonable to assume that capacity may come on as cracks widen or has refining infrastructure been so neglected so as to become unreactive? All is not risk.

Anonymous said...

This is how you get screwed. If you put on a hedge in the futures or forwards you can have situation where BOTH "legs" or positions move against you.

e.g. Short Gas, Long Oil or Long gas, short oil.

Being a former CFTC registered floor trader at the CBOT and a permit holder at the Bourse de Montreal I know all too well.