Though Monday saw the price of crude oil drop 0.8 percent to $107.17 per barrel, it has been less than two weeks since that price climbed to over $100.
Given that the US is currently in the midst of an “energy renaissance,” investors and the larger public have been somewhat perplexed by rising prices at the pump, as they have been told over and over during the past year that America will soon become the world’s largest exporter of both oil and natural gas. This has led all concerned to seek explanations for the current circumstances in factors as various as the reliable “unrest in the Middle East,” and anonymous “speculators”, to more concrete and measurable realities such as lower demand, production surpluses, and the refinery issues that have been experienced throughout the country over the past several months.
Whatever the reason, all who are concerned about the price of oil and why it fluctuates the way it does can benefit from a review of how crude is actually traded- through futures contracts.
A futures contract is an agreement to buy or sell a commodity or financial instrument at a pre-arranged future price. The contracts contain stipulations about the quantity and quality of the underlying asset to be traded, and are standardized in such a way as to facilitate trading on a futures exchange.
For crude oil, the futures exchanges with which most of us in the West, and indeed many throughout the world, are familiar are the New York Mercantile Exchange (NYMEX), where West Texas Intermediate (WTI) is traded, and the Intercontinental Exchange (IC), where North Sea Brent Crude is traded. On the NYMEX and the IC, futures for light-sweet crude oil are exchanged, with each contract, otherwise referred to as a “lot” representing the purchase or sale of 1,000 barrels at a fixed price, can extend from months to years into the future, though the bulk of activity is concentrated around contracts for three months in advance of the delivery date.
Participants in oil futures markets must be members of the NYMEX and the IC, where individual members can trade on their own, or can operate as brokers, executing orders for clients such as hedgers and speculators. In the US, oil futures trading is guaranteed by the NYMEX’s own clearing house that acts as a counterparty to both sides of the deal, creating a trade through a process referred to as “novation,” in an attempt to manage risk through the determination of general rules and margin levels.
Margin levels are particularly important for understanding how crude is traded. Participants purchasing futures do not pay the full amount of the contract they are seeking. Rather, they pay an initial margin that is similar to a deposit, and whose amount is determined by the clearing house.
In the United States, the Commodities Futures Trading Commission (CFTC) is the governmental body that regulates these trades. On the settlement or expiration date of a futures contract, both buyer and seller have an obligation to deliver or receive delivery of the financial instrument. In terms of oil specifically, a contract may be settled through the actual delivery of oil (in the US, mostly at the Cushing, Oklahoma hub), or through a cash settlement.
In general, it is uncommon for futures contracts to be settled by the actual physical delivery of a product, and investors and traders are not obligated to wait for the expiration of a contract in order to settle matters on the exchange. Often, positions are closed out or offset by buyers taking out contracts for equal and opposite amounts that cancel out their initial position, thereby balancing their obligation to the exchange.
[Image: The Trading Floor of the New York Mercantile Exchange, Courtesy of Flickr Creative Commons]
