While the collapse of overheated housing markets in key areas affected millions, high energy prices clued the entire nation into the sheer magnitude of the problems affecting the U.S. economy. Even if you didn't own a house or lived somewhere that hadn't seen the housing bubble push up prices to the stratosphere, you couldn't escape the impact that $4 gasoline and ever-rising food costs had on your monthly budget.
Now, of course, plunging energy prices have given people just about the only good news they've seen lately, as price inflation has disappeared and gasoline has fallen back to multi-year lows in just a few months. Yet scared consumers and investors alike are wondering: Will those lower prices last, or is the next wave of inflation lurking right around the corner?
It takes two to contango
One measure suggests that the low energy prices we're currently enjoying may prove a temporary phenomenon. Although what you and I pay for gasoline, heating oil, and natural gas changes regularly depending on conditions in spot commodities markets, those looking to lock in prices in the coming months and years can go to the futures markets and obtain contracts for future delivery.
In the energy markets, futures prices show a much different story from the one most people see at gas stations around the country. Although oil prices for delivery in the next month are around $38.50 per barrel, the price you'll have to pay to lock in delivery toward the end of 2009 is $57.59 -- around $20 higher based on today's contract prices. That phenomenon, known as contango, isn't unusual -- but the current extreme levels are. The same trends can be seen in heating oil, gasoline, and natural gas -- although not to the same degree.
What it means
If you take the futures markets as a guide to actual future prices, you might conclude that crude oil is poised to rebound sharply. Yet while that's a plausible conclusion, it's not the only one -- and looking more closely suggests another possible explanation.
In many commodities markets, especially those in which storing products bears significant costs, contango is normal. If you know you'll need something a year from now, you can either wait to buy it later, or go ahead and buy it now and save it until you need it. For food commodities, storage only works for a limited time. So long-term hedging strategies that producers like Archer Daniels Midland (NYSE: ADM ) might use to lock in sale prices for crops, or that food companies like Kellogg (NYSE: K ) and General Mills (NYSE: GIS ) use to ensure adequate supplies of raw crops, typically won't get disrupted by speculative trading.
Oil, however, doesn't go bad, and so storing it indefinitely is feasible. The current price discounts for near-term oil supplies make storing oil for future use look more attractive than selling it on the spot market. That's good news for companies like Frontline (NYSE: FRO ) and Teekay (NYSE: TK ) , as some traders have turned to supertankers as a way to store oil.
Once arbitrageurs take advantage of contango by buying oil and using futures contracts to lock in a profitable future sale price, what happens to the spot price doesn't affect their profits. So if the current oil glut continues, then the high prices on long-term futures contracts may fall toward today's low prices, thus averting hikes at the pump. However, for companies like Southwest Airlines (NYSE: LUV ) and FedEx (NYSE: FDX ) , which rely on futures to hedge against long-term energy price hikes, the current situation in energy will hurt -- although not as much as $150 oil did.
From a consumer perspective, the unusual price activity in energy futures may seem like cause for concern. Yet while the prospect for a rebound in oil prices wouldn't surprise anyone at this stage, you can't necessarily read the future from futures.
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