In simplest terms, the derivative (in this case, futures contracts) is causing the price of the underlying instrument (oil) to increase in price, because the value of the futures contracts themselves have appreciated due to inflation.
Analogy: let's say I'm Big Co and I want to lock in the price of oil at $90 per barrel in the next 6 months, so I buy a futures contract that will do this for me at a price of $5. If the price of oil increases to $100, then I would've saved my company $5 (price of oil at future rate - strike price - cost of contract).
On the surface, this is a good thing if:
a) There is a liquid market for such contracts
b) My company is actually buying and selling oil for the purpose of production of goods and services
Now, consider (a); it's precisely the problem he's describing. Because these banks have large positions in these contracts, it would be in their best interests to see the market value of the oil increase, since it would lead to a corresponding increase in the value of the contract. You can think of it in terms of an insurance "premium". For example, I would pay an insurance premium for my house, car etc because the intrinsic value is high, but an insurance premium for a bottle of water would be negligible in value.
The problem is made worse because the banks are not in the actual business of using oil to produce goods and services of economic value, but in fact have exclusivity to deal in these contracts.
Note that both the demand and supply side of the underlying oil itself has slight bearing on the actual value of these contracts. It's the volatility that determines the prices.
I thought this is only the case with contracts where the payoff is not linear, i.e. limiting the upside or downside. Future contract payoffs are linear f(t) = S(T) − K, so the upside is the same as the downside.
> the banks are not in the actual business of using oil to produce goods and services of economic value, but in fact have exclusivity to deal in these contracts
Can you talk more about the exclusivity here? That seems like a regulatory mistake.
Analogy: let's say I'm Big Co and I want to lock in the price of oil at $90 per barrel in the next 6 months, so I buy a futures contract that will do this for me at a price of $5. If the price of oil increases to $100, then I would've saved my company $5 (price of oil at future rate - strike price - cost of contract).
On the surface, this is a good thing if:
a) There is a liquid market for such contracts b) My company is actually buying and selling oil for the purpose of production of goods and services
Now, consider (a); it's precisely the problem he's describing. Because these banks have large positions in these contracts, it would be in their best interests to see the market value of the oil increase, since it would lead to a corresponding increase in the value of the contract. You can think of it in terms of an insurance "premium". For example, I would pay an insurance premium for my house, car etc because the intrinsic value is high, but an insurance premium for a bottle of water would be negligible in value.
The problem is made worse because the banks are not in the actual business of using oil to produce goods and services of economic value, but in fact have exclusivity to deal in these contracts.
Note that both the demand and supply side of the underlying oil itself has slight bearing on the actual value of these contracts. It's the volatility that determines the prices.