Bert, the business reporter for the Sidney Driftwood, a small newspaper, has contacted you for information about the oil market. Provide responses to his questions below with arbitrage opportunities.
a. “I understand supply and demand and the difference between the spot and the forward market. I understand that there will be an effect on the forward price of oil if an oil field in Iraq, which is expected to go into production in one year, does not go into production.
There will be a decrease in the expected supply so it makes sense that the price expected in the future (the forward price) will increase. What I don’t understand is why this causes a change in the spot price—after all the supply of oil today hasn’t changed, so why would today’s price change?”
b. “The second thing that puzzled me was the effect of hurricane Katrina on the forward price of oil. The area around New Orleans is a major storage depot for oil in the United States and there was extensive damage to the storage facilities in the hurricane. Consequently, there would have been a decrease in the amount of oil available today and, logically, the spot price would have gone up. What I don’t understand is why the forward price also rose— future oil production doesn’t depend on the availability of storage facilities today.”