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.Importantly, however, the pricetransmission is seen to work from the futures price to the spot pricerather than vice versa.That is, the spot price is determined by lookingat the front-month contract price and then discounting appropriately.This is what energy sector hedge fund manager Michael Masters meantwhen, during his testimony before a June 23 2008 hearing in the USCongress on the oil price, he made the comment quoted at the start ofthis chapter.A fuller rendition of that statement by Masters is:In the present system, price changes for key agricultural and energycommodities originate in the futures markets and then are transmitteddirectly to the spot markets.For these commodities, what happens in thefutures markets does not stay in the futures markets, but is felt almostimmediately in the spot markets.Physical commodity producers andconsumers trust and rely upon the price discovery function of thecommodities futures markets to accurately reflect the overall level of supplyand demand, pricing their spot market transactions directly off theapplicable futures price.The spot price of oil, the actual price paid in the real world by physicalusers of the commodity, is determined by the price of a notional barreltraded in a futures contract obligation, which 99% of the time will beliquidated prior to delivery.It is not necessarily attached to anyparticular, physical barrel of oil it is a paper barrel .69 Petromania2.5 Growth in Paper BarrelsPrior to the 1980s, there was not much need for active oil price hedgingin the US in particular, as the cost of domestically-produced oil wasactually regulated by the government.An increasing share of importsfrom abroad in US oil consumption, and the volatility introduced intointernational oil prices through events such as the OPEC-inspired oilshock and the Iranian revolution, made this system of regulated pricesimpossible to maintain.From 1981 the US oil price was free-floating.It is from this date that trade in oil futures on Nymex started toblossom, first sustained primarily by North American interest but, asvolumes grew and the pricing achieved credibility, then by marketparticipants from all over the world.3500000 160Oil price (weeklyaverage)1403000000Open interest inNymex light, sweet1202500000crude contract(weekly recorded)100200000080150000060100000040500000200 0DateDateFigure 5: Growth of Nymex open interest [Sources: CFTC, Thomson Datastream]70Open interest (contracts)Open interest (contracts)$ front month contract oil price$ front-month contract oil price Paper BarrelsFigure 5 shows the growth in oil futures trade on the Nymex marketjust since 2000, expressed in terms of recorded weekly open interest across the whole futures curve for light, sweet crude oil contracts tradedon the exchange.For comparison, it also shows the path of the oil priceitself (as determined by the front-month Nymex light, sweet crudecontract) through this same period of growth in open interest.Openinterest is the most commonly used metric to refer to the size of a futuresmarket, and references the number of contracts extant for delivery atany one time, i.e.not including offset contracts within the reckoning.Assuch, it is not quite the same as a simple trading volume measurement and here is our introduction to the sometimes counter-intuitive natureof the additive rules of open interest.In the beginning was the contract; and the contract had two sides;and the exchange saw that it was good.We can imagine some pristinefirst dawn of futures trading on a particular exchange, the momentwhen its first ever deal, for just one contract, is struck by two marketparticipants for a particular date.At that point, open interest on theexchange is one contract, a contract by definition having two ends: oneend being the single buy obligation incurred in trade to date, and theother end being the single sell obligation incurred in trade to date.Notlong afterwards, another deal is concluded between two other marketparticipants for exactly the same date, and open interest in thatparticular contract maturity has now climbed to two contracts.Imagine, however, that when the next punter comes to the exchangeto buy a contract for delivery on that exact same date again, there isactually no one else likewise newly-come to the exchange seeking tosell that obligation.The punter is in luck, however.One of the buyersin the previous deals is now already unhappy with the obligation theyhave incurred, fearing they will no longer have use for the commodityin question on the delivery date.They are willing to sell out of this71 Petromaniadelivery obligation to the newcomer so that the latter will take it overfor them, and the latter is willing to do so.A third deal is agreed.Soopen interest on the exchange is now three contracts? No, it remains attwo contracts because, despite the participation in three deals to dateon the market by five parties, they have between them only dealt acrosstwo whole contracts.Open interest would only have grown to three iftwo newcomers had struck a brand new deal, a new contract sale andpurchase, between themselves, rather than a newcomer facilitatingsomeone selling out of a previously dealt contract.Contrariwise, open interest on our newborn exchange could actuallyhave shrunk back to just one contract on this third transaction if,instead of having to wait for a newcomer to turn up willing to buy himout of his obligation, the antsy buyer was seeking to offset just as theseller on the other existing outstanding contract also decided it was intheir interests to abandon their own position.The antsy buyer is seekingto sell the same contract that this latter participant is seeking to buy atthe same moment, both of them seeking to reverse their earlier trades
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