Thursday, August 25, 2005

How not to bet on the future

In an interesting coincidence, this article appeared in the New York Times a day or two after my bet was announced. The article, entitled "The $10,000 Question", concerned a $10,000 bet...but not mine. Instead, it was a bet on future oil prices, with one party arguing that the oil price will be above $200 by 2010, and the other arguing that it will be lower. Actually, the bet was only $5,000 v $5,000, so $10,000 in all.

Well, maybe I'm missing something, but we already have a large betting market on future oil prices...and it's helpfully called the "oil futures market". It suggests a price in the region of $60 by the end of 2009 (eg here, I don't really know where the best info is).

Therefore, anyone who thinks that the future oil price will be actually higher than that, can buy a future delivery of oil at that price. They don't need to actually be prepared to take a physical delivery of oil, they can simply sell the future contract nearer the date.

So, it seems to me that the person who bet on an oil price of over $200 was rather silly, because they could have got a much more profitable and lower-risk deal from the existing market. And that's before we even start with put and call options which could probably leverage a very large return on a small investment. If anyone else wants to place such a bet, please let me know - I will take willingly you on, hedge on the existing market and make a large risk-free profit.

A rather more attractive oil bet (from the "alarmist" point of view) can be found here. A drop to $25 by 2010 seems pretty unlikely right now.

Ok, I found some futures and options data here. It looks like you can buy a "call option" for Dec 2010 oil at $70, for a price of say $4 (assuming I'm not misreading the site - it is not entirely clear to me). That $4 gives the owner the right (but not the obligation) to buy oil at the stated price and date. So if the oil price is $100 at that time, that nets a profit of $26 on a stake of $4. At $200, the return is $126. I'm sure that Matthew Simmons (who took the high side of the $200 oil bet) knows all this, so I conclude that he is giving away $5000 as a publicity stunt to push sales of his new book. Or maybe he's just trying to prove that doomsayers are stupid.

Anyway, I have no book to promote - yet :-)


Anonymous said...

How accurate was the 2001 futures market with respect to current pricing? I don't know, but my guess would be that it completely missed the current run-up. Since the futures market can really only be based on an expert assessment of likely future conditions, to the extent that the futures experts (whoever they are) assume they're not being lied to by the Saudis (about the state of their fields) and the big oil companies (about their reserves), then they are probably guessing low. $140 low does seem a little risky, though. It's interesting that the other bettor wasn't willing to go with a lower bet, but maybe it was a sucker situation.

Also, how good are futures markets generally at accurately forecasting future prices, and especially peak prices, while at a peak? Someone somewhere must be studying this.

JMS said...

Matt Simmons is an energy investment banker -- he's better aquainted with the oil futures market than Tierney, the columnist who proposed the bet in the first place.

As for whether or not he is proving doomers (and himself) stupid...

Not this time.

James Annan said...

So, monkeygrinder, is that an offer to bet on the same terms as Tierney v Simmons? I reckon you're bluffing.

My main point is not whether oil may reach $200 or not, but whether the bet was a sensible and useful one. With the market already providing odds of at least 30:1 against it happening, it's a stupid bet for Simmons to make even if his hunch turns out to be right (he could have made ~$150,000 rather than $5,000). OTOH, $5,000 to publicise his new book may be a good deal.

Steve...will try to address this in a longer post.

Anonymous said...

Have you noticed the price of these options seem to be increasing since all this blogging on betting on oil. For example Dec 2008 at an excercise price of $70 increased from 2.1 to 7.4.

Do you think it is a result of the blogging?

James Annan said...

It had certainly crossed my mind that Simmons might have previously bought some oil futures, and be trying to talk up the price now so as to rake in some quick profit :-)

His bet and Katrina together have certainly got people talking about continued high prices in the medium term. Not sure that "the bloggers" themselves would have had an impact - for every one cheering his bet, there must be at least two saying it is ridiculous. OTOH $80+ oil doesn't seem quite so far-fetched any more...

Anonymous said...

I doubt the bloggers would have any impact unless some of them are buying or selling options. I doubt the people saying the bet is ridiculous are selling call options. A small proportion of those cheering the bet might be deciding a much better gamble is worth going for.

It is even just about possible that some saying the bet is ridiculous are buying call options.