What Are Oil Futures?

That’s a good question. What, exactly, are oil futures? You’ve probably seen the term online, or heard talking heads discuss oil futures and contracts and prices and other terms associated with the world’s most important commodity.

Oil futures are contracts to exchange a certain amount of oil for a certain amount of money at a certain date in the future – hence the term, futures contract. Unlike an option, which gives a buyer of an option contract the right to purchase a certain asset when the contract expires, a futures contract represents an obligation to either take physical delivery of the asset or settle the contract for cash.

Here, we’ll sort through oil futures contracts and explain what it means to buy and sell oil through these instruments.

The Basics About Oil

Oil, as I mentioned, is arguably the world’s most important commodity. It is also the most traded commodity in the world when it comes to futures. Oil is used in countless industries and products. Roughly 43% of each barrel of oil (roughly 42 U.S. gallons in one barrel) is used for automobile fuel; 23% is used for diesel and heating oil; 9% is used for jet fuel; 3.8% is used for electrical power generation; and the rest is used for petrochemicals and lubricants.

As of September, 2012, global demand for oil is estimated at 90.2 million barrels of oil per day. That comes out to 32.9 billion barrels per year. Right now, supply is at or slightly above that number, but in the future, if demand continues to rise as expected, supply could become constrained – which means oil prices could continue to rise.

When we talk about oil in the context of oil futures contracts, we are mainly talking about a specific type of oil: light sweet crude. ‘Light’ refers to how easily the oil flows and its density; ‘sweet’ refers to the fact that this type of oil contains less than 0.42% of sulfur. Both qualities mean you can make a wider range of products and get more gasoline and other refined products from one barrel. For this reason, it’s the most in-demand version of oil in the world.

In terms of price, there are two primarily benchmarks: West Texas Intermediate (WTI) and Brent Crude. There are others, like Dubai Crude, but most are quoted according to those benchmarks.

Oil Futures

As mentioned, an oil futures contract is an agreement between two parties to exchange a certain amount of light sweet crude oil for money at an agreed-upon price at some point in the future. The two main exchanges where this trading occurs is the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE).

For example, let’s look at a contract on NYMEX. We’ll take a look at a contract for delivery in February, 2013. The current price for that contract is $97.50 per barrel. The symbol for this contract is CL, and one contract unit gives you control of 1,000 barrels of West Texas Intermediate.

To trade, you have to be aware of margin requirements. Since one single contract controls a 1,000 barrels of oil – which has a market value of $90,000 at $90 a barrel – you have to post what is called a performance bond. For the February 2013, contract, initial margin is $6,548 and maintenance margin is $4,850. That means you have to have $6,548 in your account to open a futures position, and a $4,850 at all times to keep your contract.

Factors that Influence Oil Futures

To trade oil successfully, it’s not enough to know the specifics. You have to know what pricing factors are out there in the market that impact the price of oil, so you can estimate what the price will be a month, two months, or even a year from now.

Global Consumption

One of the main factors driving the price of oil is a steady rise in global oil consumption.

With the exception of 2008 to 2009, when a global recession was in full swing, global oil consumption has steadily increased for decades over the long run. This is because more and more people – especially in populous, developing nations like China and India – are using oil-based products, namely gasoline. In fact, there are serious concerns that, barring some new technological development, demand will begin to outpace supply, resulting in price spikes.

Geopolitical Events

Oil is very sensitive to geopolitical events – anything from terrorist attacks and wars to global economic reports (especially from the Organization of the Petroleum Exporting Countries, a mostly-Middle Eastern cartel of oil suppliers). It’s not uncommon for poor economic performance to drive down the price of oil, just as it is not uncommon for any threat to supply disruption to drive up the price of oil.

Speculation

There’s no denying that speculators – those who seek to cause fluctuation in a commodity’s price for profit – play a big role in the price of oil. Speculators are loosely defined as anyone who trades in oil but is not a user of oil or a producer. Since the vast majority of contracts traded don’t actually result in physical delivery of oil, it’s clear to see how much speculation can influence price.

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