How Do Crude Oil Futures Work ?
Oil futures are a kind of financial contract entered between the buyer and seller for a specific volume of oil for a particular price, which has to be paid by a specific date. This kind of trading is done by speculative investors, who try to speculate on which way the price of oil will move. In addition, crude oil futures trading is also done by producers, who use the trading as a way to hedge their risk of owning the oil. Generally, the contracts entered are closed before they expire. |
Most crude oil futures are traded on the NYMEX, which stands for the New York Mercantile Exchange. Majority of the crude oil futures traded here are described as light and sweet as the crude has a low content of sulfur. Each contract that is entered into is for 1,000 barrels, which is equivalent to 42,000 gallons of crude oil. The contracts are always in US dollars. The other crude oil futures that are traded on the NYMEX are Brent crude oil futures as well as Russian export blend crude oil futures. (See Reference 1)
One of the most used strategies in this kind of trading is known as short hedge. This strategy is primarily used by producers of crude oil who want to protect the value of the oil that is present in their inventory. For instance, a producer of crude oil produces one thousand barrels of crude each day and decides that he wants to hedge his production for the month, so that he gets $100 for each barrel. So, this producer sells 30 futures contracts wherein each barrel is for $100. If the price of crude oil increases more than $100, the producer will close the contract and sell the crude for a loss; and this loss is then offset by selling the oil physically at the prevalent price. On the other hand, if the price of crude per barrel becomes less than $100 for a barrel, then the producer gets a profit on closing the contract; and this profit is offset by selling the physical crude at the lowered price. (See Reference 1)
The other way that crude oil futures work is the long speculative way. This is best explained using an example. Say a analyst working for hedge fund is of the opinion that the oil inventory report that is going to come out later in the week will reveal that there is a significant drop in the crude oil inventory instead of an increase, which the crude oil market is anticipating, he or she will go ahead and purchase 30 crude oil futures contracts at a price of $100 for a barrel. Once the report is released and is as per the analyst's expectation, there will be an increase in the price per barrel of crude oil. Assuming that the price has increased from $100 to $104 for a barrel, the analyst can make a profit by selling the contract. (See Reference 1)
Crude oil futures trading is regulated by the Commodity Futures Trading Commission in the US. This commission was set up in the year 1974 after the US Congress passed the Commodity Futures Trading Commission Act. (See Reference 1)
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How Do Crude Oil Futures Work
If you are wondering how does the oil futures market works, then will be surprised to learn that the contracts of oil futures are traded on exchanges. In the US, there are 2 exchanges where oil futures are traded. These are the NYMEX and New York Board of Trade. Here speculative trading of oil futures occurs.