Incentives for Default in Oil Forward Contracts

Question: 

Suppose that oil prices decline by 50%. Which counterparty to a forward contract in oil has an incentive to default on the contract? Briefly explain.

Answer Description:

In a forward contract, the price of the commodity is agreed upon in advance, and the contract requires the buyer and seller to transact at this agreed price regardless of future market conditions. If oil prices decline by 50%, the counterparty who would have an incentive to default on the contract is typically the seller of the forward contract.

Explanation:

Forward Contract Basics:

Forward Contract: A contract in which two parties agree to buy or sell a commodity at a predetermined price at a future date.

Seller’s Obligation: The seller agrees to deliver the commodity at the agreed-upon price.

Buyer’s Obligation: The buyer agrees to purchase the commodity at the agreed-upon price.

Impact of Declining Oil Prices:

If Oil Prices Decline: Suppose the forward contract was set at $100 per barrel, but the current market price has dropped to $50 per barrel.

Seller’s Situation: The seller must deliver oil at the agreed price of $100 per barrel. Given that they could now buy oil from the market at $50 per barrel, they are incurring a loss of $50 per barrel.

Incentive to Default:

Cost-Benefit Analysis for Seller: Since the market price is now much lower than the contract price, the seller has to provide oil at a higher price than the market price. This loss motivates the seller to default on the contract if the consequences of default (e.g., penalties, legal costs) are less than the loss incurred by fulfilling the contract.

The seller of the forward contract has the incentive to default when oil prices decline significantly because they would incur a substantial loss by having to sell the commodity at the previously agreed higher price while being able to purchase it at a much lower market prices.