Monday, October 15, 2007

Arbitrage, Free Money

As markets continue to go straight up, arbitrage becomes more profitable. Suppose an oil refiner takes delivery of oil today at $70 purchased 3 months ago. Now on the day they take delivery, futures three months out for oil, are $83. Figure their cost is two dollars for storage and interest per barrel (over a 3 month time). They can make $11 ($83-$70-$2) per barrel without refining it, by selling a forward futures contract 3 months out. In this case, the oil refiner can make more money storing the oil than refining it. The company could still buy spot oil and run their plant at full tilt. Notice, a refinery doesn’t care what the price of oil is; they refine it at a set price.

With low interest rates, futures arbitrage is more profitable. Remember that forward future’s costs are determined by storage charges and the cost of the money (interest) tied up in the contract to its expiration date. In a drastically rising market, it is more tempting to take your current delivery contract and move it forward 3 months. It doesn’t matter what happens to the price during the three months, somebody else owns it at an agreed price. The arbitragers profit is locked in.

If the three months futures premium on gold was $35 dollars above the spot price per troy ounce, the arbitrage play would be to buy the gold and sell the futures on it. $35 times 4 quarters is about $140 per ounce profit. You can keep rolling the futures forward. If the bottom dropped out of the gold market, the arbitrager would deliver the gold and keep the cash. In this example he would buy 100 ounces of Gold for say $70,000 and sell the future contract three months out for $73,500. The $70,000 kept in the bank at 5% would have earned $875. This, plus storage fees, would have been his carry cost for the trade (gold is higher, I just kept the math simple).

The arbitrager would select commodities with high volatility. There will be more premium loaded into that contract. Remember he is not buying gold or wheat or whatever. He’s holding a commodity for promised delivery three months out. The premium is the paycheck. Here is where it gets interesting. A majority of the futures contracts are bought back before expiration. If the commodities stop going up, all of these arbitragers are going to deliver the stored product. This might be more product than the spot market would be comfortable with. Ergo big price drop.

There are three different participants, suppliers, arbitragers, and speculators. The suppliers and the arbitragers have the ability to roll their contracts forward. If the speculators are willing to pay more premium because of implied profits, notice what happens. Instead of the commodity for example oil, hitting the spot market, it is rolled forward three months by not only the arbitrager, but the supplier for a better return. So, if I have this right, you can be knee deep in oil and not have a drop to refine. Isn't that neat, I pay more now, for gas because it's more profitable to deliver raw crude three months in the future. Go figure!


Anonymous said...

If what you say about oil is true, then the spot price for RBOB gasoline would be much higher. Because of the implied shortage of the refined product, however, this is not the case right now, actually, the price of gasoline is not keeping up with price of crude.

am I missing something here?
In any case, you bring up a good idea but I don't know about its feasibility.

Jim in San Marcos said...

Hi Anon

Spot prices are pretty reliable as current prices. Futures prices have no anchor to the real market, you are dealing in speculation. If everyone rolled over their futures 3 months ahead, and oil doesn't increase in price, you will see spot oil drop drastically.

The other thing when you compare gasoline to oil, is the fact that "cracking" the oil a certain way can make gas or heating oil. So if you have a higher profit on gasoline, you will "crack" the product to the gasoline side.

I think that when you get to pure product ie gas, fuel oil, the speculation for profit in futures is pretty much gone.

I'm not talking theory here, if you listen to the Jim Rogers piece, you will see that he is rolling forward wheat futures. All of your hedge funds are doing just what I have been discussing, there is no feasibility issue here, this is straight finance 101.

You buy the product and sell the future. There is no risk, you get the premium (future price minus spot price). 20% a year might not seem like much but you can double your money every 3.6 years.

JIMB said...

Speculators make the other side of the market from arbs and if they feel the price is too likely to fall, they won't play the game, being in a position to lose big.

Jim in San Marcos said...

Hi Jim

I would bet that the speculators are buying spot to cover the contracts they sold and need to deliver on.

Oil Futures for 24 months out are showing about $75 per barrel, so there is no incentive to buy spot and sell the futures from an arbitrage mind set.

After oil settles on Monday, you could have an air pocket in the oil futures. Like a big drop in price.

If the price of oil stays at $90 rest of the world will cease consuming oil and ride bicycles. The third world cannot afford oil at $30 per barrel.

Something is severely out of whack.