Definition

Oil Futures

What are oil futures?

After gold, crude oil is the most traded commodity in the global market. The movement in the crude oil prices impacts the prices of several commodities and currency exchange price of the United States dollar. Many major listed companies in globally significant stock exchanges like NYSE and LSE are oil producers, and the movement in oil prices affects the indices of stock exchanges as well.

Since oil production is limited, demand and supply variables can fluctuate the prices significantly. Oil futures represent an instrument that can be traded in exchange and is often used by traders and oil companies to hedge against possible adverse price scenarios.

What are oil futures?

 

Oil futures are contracts in which traders agree to take the delivery of the crude oil on a fixed date in exchange for a set price of the contract. Oil futures are traded similar to other futures contracts in the stock exchange, and the position could be sold out at any time before the expiry date of the contract. If it remains unsold, then the buyer of the contract has to take the delivery of the crude oil.

Which are the most popular oil futures markets?

To answer this question, we have to first know about two crude oil benchmarks used globally. They are Brent Crude and West Intermediate Texas (WTI) crude oil. Brent crude comes from the British-controlled part of the North Sea, and WTI is produced from the onshore oil fields of Texas.

Both crude oils have low density and very low sulphur contents. They are high-grade crude oils that yield the highest volume of gasoline, which is the most desirable component of crude oil.

All the other crude oils are benchmarked with these two, and price is decided as per the relative grade. There are several other benchmark crudes, but these two are the prominent ones.

Now, Brent crude is traded at the Intercontinental Exchange (ICE) of Europe, while WTI crude is traded at the New York Mercantile Exchange (NYMEX).  

What factors contribute to the price fluctuations of oil futures?

Just like the futures contracts of other commodity and stocks, there are traders who take short and long positions for oil futures. The prices fluctuate significantly due to the short position buyers who tend to exit their positions when there is any abnormal price surge due to any geopolitical or demand and supply issues.

Recently, crude oil prices surged up to 6% when the merchant ship Ever Given was stuck in the middle of the Suez Canal, obstructing the water traffic from both sides. In a situation like this, most people buy contracts in speculation of the price rise. The short position holders will sell off their positions either in loss or with eroded gains. To cover for their losses, they will also jump in to buy the contracts, thus moving the future contracts swiftly to higher levels.

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The crude oil price market is highly volatile, and trends can change overnight. Be it government policy change or geopolitical issues – various incidents in the global market impact the prices. Traders need to keep a vigil on overall market sentiments all the time when they are holding a particular position. The COVID-19 wave of the last year eroded the demand of crude oil significantly when there were lockdowns and travel restrictions. The May contract of 2020 slid to the negative side even when traders were not in a position to take delivery of more oil as stocks were already full.

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Summary
  • Brent crude and WTI are the most popular benchmark crude oils which are traded as oil futures contracts.
  • Brent crude is traded at the Intercontinental Exchange (ICE) of Europe, while WTI crude is traded at the New York Mercantile Exchange (NYMEX).
  • A futures contract is used to hedge against the future volatility of crude oil prices by traders and refiners.
  • Crude oil prices fluctuate with season, geopolitical incidents, trade relations between the countries, OPEC decisions, inventory of US stockpiles and many other factors.
  • Futures contracts involve taking delivery for the crude oil on a fixed date and a fixed price of the contract at the time of buying the contract irrespective of the market conditions.

How does a futures contract works?

Let’s suppose the current price of crude oil is around US$60/bbl for WTI. Now, suppose I am a refiner who needs dependable crude oil supply throughout the year.  In my opinion or analysis, the demand for crude oil will rise, and prices could move swiftly to higher levels in the next six months or one year.

To keep the refinery margin profitable, I would go for the futures contracts  based on the current data. I will secure the supplies for future at the current market price, thus hedging from the future price rises. The suppliers also tend to work in the same way. If suppliers believe that the current market price is optimum and prices may slide little in the coming months, they go for futures contracts for their produce.

Due to the outbreak of COVID-19, the OPEC countries pledged for a reduction in production, thus declining the supply of crude oil in the market to support the prices. If a refiner would have purchased the contracts before the announcements at lower prices, it must have reaped massive benefits in the future supplies which were priced higher.

Is there any other type of contract to trade crude oil?

Crude oil is also traded in the ‘spot market’ where crude oil is traded in large physical quantities in near-term delivery contracts. Since these trades occur for the short term, they play an important role in deciding the long-term contracts.

In a spot market, buyers are mostly refiners and sellers are the crude oil producers. Negotiations are held one to one and can vary among the buyers on the same day. The payment terms like currency and relation between the countries play an important role in setting up the prices. For example, crude oil prices for the crude coming out of Syria will be lower as there is instability in the country and most refiners refrain from buying due to global pressure.