Question

On March 20, the spot price for Saudi Light Crude Oil stands at $85.20 a barrel, while the August futures contract for Saudi Light Crude stands at $86.32 per barrel. Based upon this information answer the following questions.

a. Determine what the basis for Saudi Light Crude on March.

b. Based upon this basis value, would you expect normal backwardation or contango to occur in the futures market as the August oil futures contract moves toward settlement? Briefly explain.

c. The following month (April 20) the spot price for Saudi Light Crude goes to $85.25 per barrel, while the August futures contract price moves to $83.10 per barrel.

1. Determine the basis value for SLC on April 20.

2. Has the basis for oil strengthened or weakened between March 10 and April 20? Briefly explain.

3. Based upon this new basis value for Apr 20, would you expect normal backwardation or contango to occur in the futures market as the August futures contract moves toward settlement? Explain.

Answer 1

The difference between the spot price and the futures price of a commodity is the basis.

Basis = Spot Price of asset to be hedged - Futures Price of contract used

a. On March 20

Spot price =  $85.20 per barrel
Futures price = $86.32 per barrel
Basis = $85.20 - $86.32
= -$1.12
b. Since the futures prices are higher than the spot prices, we'd expect contango in the futures market as the futures contract moves towards settlement.

c.
1.

0n April 20
Spot price = $85.25 per barrel
Futures price = $83.10 per barrel
Basis = $85.25 - $83.10
= $2.15

2. Since the basis has increased from -1.12 to 2.15, the basis has strengthened.
If the basis strengthens (increases) unexpectedly, the hedger's position improves; if the basis weakend (decreases) unexpectedly the hedger's position worsens. For a long hedge, the reverse holds.

3. Since the futures prices are lower than the spot price, this depicts backwardation in the market