Futures Contracts and NYMEX

okay let's start reviewing what are the futures and before that I will need to explain forward what contracts first. So, forward contracts, let's say on the left-hand side we have an oil producing company on the left on the right hand side we have a refinery which consumes oil and produces some refined products. So, on the left hand side we have producer that sells the oil on the right hand side we have consumers that buys the oil. So, let's say right now the refinery needs some crude oil the producer has some oil. They just sell and buy and that's it. Okay, but this is an ongoing business activity, right? The producer knows that for anytime future they know the production rate and they know how much crude oil they will have in the future. Also refinery this is a continuous production process, they know they're going to need a crude oil for almost any time in the future, right? Both of these are concerned about market fluctuations and also they want to make sure they market for crude for the produced crude oil or they can have the crude oil that they need. And also they're concerned about the price. The producer is concerned that, okay what if price drops, we're going to lose money. On the other side the refinery is concerned that if price goes up we're going to lose money and they want to hedge their risk against price fluctuations. So what we can what they can do is, they can negotiate a contract which is called forward and they can discuss three things: time, price and quantity. And let's say we are going to sign a contract that sometime in the future, let's say in November, at the locked price of 50 dollars the producer is going to deliver some specific quantity of crude oil let's say 5000 barrels to the refinery. So, they have a contract that locks the price for delivery in some time in the future and they can have many of these. So, this is called forward contract. And by doing that they first make sure the producer has a market for crude oil, the consumer they know for sure they will have crude oil in November. Also, they know the price is locked. The price is locked. They lock the price 50 dollars. The price doesn't change. Okay what are the kind of them restriction, limitations, of these forward contracts?

Okay first let's say these two entities, the producers and consumers, they're not exactly the same size. Let's say the refinery is a very large, or the producer is very large producer, one of them is a lot smaller or larger than the other one. So, then, they have to go and probably find 10 other counterparties to find, negotiate, and sign the contract for each of them and they have to do it for almost every month, soon and so forth. It's doable, it is still uh an ongoing activity in the financial market, but it's not the most efficient way of doing it.

The other problem with this is, let's say this contract is signed to deliver the crude oil in November and the price is locked at 50 dollars. Let's say, a couple of months to the November, let's say price of crude oil goes up. Let's say it goes to sixty dollars. So, if it goes in the market it's sixty dollars, but under this contract it is locked at fifty dollars. So, because it is locked, then, the producer loses money. Because, if there was no contract producer could have sold it in the market at sixty dollars. So, the producer will get more and more upset that, okay, I am losing money under this contract, but there is no way that they can cancel the contract. On the other side, if price of crude oil starts going down, the producer is happy but the consumer cannot uh cancel the contract and go and buy the cheaper oil in the market. They have to pay the 50 dollars for locked price. So the problem is they cannot cancel the contract at all.

So, this is the kind of the introduction how there is a better more efficient type of contract needed based on the forward and that's going to be called futures, which I’m going to explain in in a bit.

Okay, now let's make some changes and move toward that more efficient contract which we'll call it later on futures. Okay, the first thing that we want to do is, we want to introduce the third party here. And let's say, we call this third party, and say instead of producer going and trying to find consumers, these producers will just go and sign a contract with this third party, call it exchange or call it a businessman, businesswoman, a company. And the consumer, the refinery, will also go and signs the contract with this third party. So, it solves the problem that they don't need to go and find, let's say 10 more, consumers and sign individual contracts for them.

Let's make some little more adjustments. Let's say we make these contracts standard. You remember in the previous slide I said look at these contracts, these forward contracts are case based? they are signed for the specific case and between these companies and their contract terms are negotiated between these two entities?

Now let's introduce a type of contract that is, all the terms are standard, there's nothing negotiable. These are all fixed in place and nobody can change them. The quantity is fixed, the delivery point is fixed, the price is fixed, which I’m going to talk about the price in a bit. And everything is fixed under these contracts, except the delivery date. And delivery date goes by the incremental month. It's either January or February or March, so on. The only difference between these contracts is the delivery date or expiration date. So, when we make these contracts exactly similar, there's no need for any negotiation back and forth. So, we will have these standard contracts and what we can do is we can have all the other entities to join this market and trade these contracts.

So, what will end up with an exchange in the middle, which will have these contracts, they are all standard, exactly the same. And we have these players that the actual producer the refinery and the oil producing can also join as one of these players in the market. So, they can either buy these contracts or they can sell them. If they buy this contract, we call them their position is long. If they sell this contract their position is short.

If they buy the contract, long position, they have to take the delivered crude oil, they will receive the crude oil when contract expires. On the other side, those players, those entities who sold the contract, their position is short. They have to deliver the crude oil, the amount of crude oil at the expiration date.

Because, these all these contracts are exactly the same, these are called futures. They have the fixed quantity, one thousand barrels of crude oil, the delivery point is fixed, Cushing Oklahoma and the spec is WTI, West Texas Intermediate and that's low sulfur, sweet, crude oil and the expiration day goes by the month, January, February, March and so on. The price is set by these trades by these market movements, sell and buy, supply and demand. If somebody does not like the loss that they are making, based on the price movement, they can get out of the contract anytime they want. They don't have to wait until the expiration date. If the prices are going up and the position is short, they can just immediately close the position by buying back, buy closing the position with the exchange.

The entities who are long these contracts, the entities who bought the contracts, will make money, will profit, when price goes up. On the other side, if an entity has a short position, will lose money. If price starts to go down, long position will lose money and short position will make money.

Okay, an important point here, these contracts are binding. The entity, the party that is short, the part that sold this contract, has to deliver crude oil at the expiration date. If that party is not an oil producing company, or if that party is not interested in delivering or cannot deliver the crude oil, they have to close their position, they have to cancel the contract. How? if they are short, they have to buy back; if they are long, they have to sell.