Financial energy commodity contracts are traded on the New York Mercantile Exchange. The picture at the left side of the slide here, the actual building with the reflection of the sun on it, is the New York Mercantile Exchange building on the Hudson River in New York City. To the right is an actual picture taken with the traders trading in the pits, as they yell and scream back and forth at one another, placing the orders.
The New York Mercantile Exchange started in the 1800s. There were scattered markets for the goods in large cities. You can picture a city like New York City and agricultural products being brought in and sold in various parts of it. So some entrepreneurial businessmen decided that they needed a central exchange. So in 1872, it was founded as the Butter and Cheese Exchange. In 1880, it was changed to the Butter, Cheese, and Egg Exchange. And then finally in 1882, it was changed to its present name of the New York Mercantile Exchange.
Later products would include yellow globe onions, apples, potatoes, plywood, and platinum. Platinum is the only product which is still traded today on the New York Mercantile Exchange. So today, it trades crude oil, heating oil, gasoline, propane, natural gas, platinum, and palladium.
Futures contract. The definition given by the New York Mercantile Exchange is a legally binding obligation for the holder of the contract to buy or sell a particular commodity at a specific price and location at a specific date in the future. The key word here is future. These are known as futures. We are buying and selling energy commodities at a future date and time. And again, this is a legally binding obligation. This is what makes exchanges a sound place to conduct business. If you fail to perform under a contract obligation with the New York Mercantile Exchange, there are both financial and legal ramifications.
The components of a standard NYMEX energy contract. First, we name the commodity-- crude oil, natural gas, heating oil, unleaded gasoline. The price, which is what most times we are most interested in. The location-- each of the energy commodities on NYMEX has a different delivery location. And then the date. What the future point in time do we wish to buy or sell the energy commodity?
The trades on the New York Mercantile Exchange between the counterparties are conducted under the International Swaps and Derivatives Association, or ISDA, 2002 Master Agreement. This is a standardized contract under which all financial energy commodity contracts are traded.
One of the primary functions of energy contracts on the New York Mercantile Exchange is that they provide us price discovery. We can establish a price for crude oil, natural gas, heating oil, and unleaded gasoline for any future point in time. Years back, prior to the advent of the New York Mercantile Exchange, no one could really tell what the price was at any point in time. Most trades were conducted over the telephone. But now, with the New York Mercantile Exchange, at any point in time, you can look up the live trading. The New York Mercantile Exchange is owned by the Chicago Mercantile Exchange or the CME Group. If you go to cmegroup.com, you can see the commodity prices. There are some links to that on the home page of the course module here.
In addition, this allows us to perform what we call hedging. Hedging is to reduce risk in a transaction. In the case of the futures contracts, it helps us to reduce our price and/or physical risk. We may be concerned about high prices if we're a consumer of energy commodities. We may be concerned about low prices if we are a producer of energy commodities. We may also be concerned about receiving physical supply or having to guarantee physical market. The New York Mercantile Exchange contracts guarantee that.
Some of the common terms used by NYMEX. An ask-- an ask is a motion to sell at a specific price. It's the same as an offer. So ask and offer are interchangeable. It's your asking price. What do you wish to get in the marketplace for your commodity? And notice this is a motion because they're addressing the idea of the physical trading that takes place in the pits, the movement of hand gestures back and forth as traders buy and sell. A bid, then, is the opposite. It's a motion to buy at a specific price. What is your bid for the energy commodity?
A bull-- in this case, we're talking about a person. It's one who anticipates prices will increase or volatility in the market will increase. They're the opposite of a bear. A bear is one who anticipates a decline in price or the volatility in the marketplace. Obviously, the opposite of a bull.
This is a picture of the New York Mercantile Exchange trading floor. It just so happens in the foreground is the natural gas trading pit. Off to the left, barely seen, is the crude oil trading pit. Notice the various colors of jackets around the floor. I will identify who some of those are in a minute. But the yellow jackets, for the most part, those are NYMEX compliance personnel. The multi-colored jackets, the blues, the burgundies, some of the other colors, represent brokers, what are known as clearing brokers on the floor of the New York Mercantile Exchange. They have posted credit, and they have licenses to trade on behalf of their clients.
So we have the floor brokers, which I mentioned. We have locals. These are the individuals and firms and in some cases funds that have a large amount of money and wish to trade. They are speculators. They're not interested in the physical commodities whatsoever. They're interested in price movement, and wherever the price is moving, that's where they want to be.
Ring reporters and ring chairmen-- we'll drop back here a second, and I will show you. The ring reporters are in the yellow jackets near the trading rings themselves. There is a podium, if you can tell, situated above the natural gas pit with some personnel in yellow jackets. Those are the ring chairmen. Their primary responsibility is to oversee the activity of the pits and to resolve any disputes. Since we have people who are yelling orders back and forth to one another and using paper slips, sometimes mistakes can be made, and if there's a disagreement over the actual details of a trade, the ring chairman is supposed to step down and resolve that trade between the two counterparties.
We have floor committee members. Those are basically NYMEX committee members. The New York Mercantile Exchange also has compliance people. And the Commodity Futures Trading Commission is the regulatory body for energy financial derivative trading. They have their own personnel on the floor as well. And then there are hundreds of line staff from the New York Mercantile Exchange.
We'll now talk about each one of the specific contracts for energy commodities. The first is crude oil. The symbol is CL. We refer to this as West Texas Intermediate, or WTI crude. It is low sulfur, and so, therefore, is given the nickname sweet crude. The NYMEX contract for crude oil was initiated in 1983. Every contract represents 1,000 barrels, which is the equivalent of 42,000 gallons of oil. Price quotes on the New York Mercantile Exchange are all US dollars and cents, in this case per barrel. A minimum price fluctuation-- that is, the amount that the price has to move for a trade to take place-- is a penny, or $10 a barrel.
The delivery point for crude oil under this contract is what's known as FOB, or free on board, or delivered to the seller's facilities at Cushing, Oklahoma and to any pipeline or storage facility with access to Cushing Storage, TEPPCO, or Equilon pipelines. So if you buy or sell crude oil contracts on NYMEX for a particular month, you are obligated to either receive the crude oil or deliver the crude oil at Cushing, Oklahoma.
Deliveries are to be made uniformly across the month. This is the contractual obligation. The idea here is to make all parties deliver as equally as possible. The actual obligation-- for instance, if I sold 30 contracts for the month of September, that means 30,000 barrels of crude oil-- the Exchange would like me to deliver that at 1,000 barrels a day. However, if I cannot, my real legal obligation is 30,000 barrels for the month.
The trading hours on NYMEX for what we consider to be the open outcry or pit trading, the general session where the traders are in the pits yelling orders back to one another, run from 9:00 AM to 2:30 PM Eastern Standard Time. The Chicago Mercantile Exchange also has an electronic trading platform known as Globex, and this is virtually 24 hours a day, seven days a week. It starts at 6:00 PM on Sunday evenings and ends at 5:45 PM on Friday, Eastern Time.
Crude oil can be traded for up to nine years. And then we also have products that are known as strips. These are available for terms of 2 to 30 consecutive months. In essence, strips amount to an average price. If I wanted to buy six months worth of crude, rather than go out and have my broker quote me one month's price at a time, they'll just give me an average price across the six months. Therefore, I am purchasing a six-month strip of crude oil.
The last trading day, every contract expires. Again, we are talking about future contracts. So currently, the closest future contract is September. The crude oil contract, then, settles three business days prior to the 25th of the month. So just in case the 25th is a non-trading day, either a weekend day or a holiday, the settlement occurs three business days prior to the business day that is prior to the business day ahead of the 25th. I know that sounds very confusing. I can't quite figure it out myself half the time.
Margin requirements. This is a big issue here. You can see that if you want to buy or sell crude oil contracts, for every single contract that you wish to enter into, you have to have $5,100 in a margin account. That's a safety net against losses that you could incur. This protects your clearing broker and protects the New York Mercantile Exchange from default by you as a counterparty.
This also discourages a lot of traders from just jumping in and trying to trade contracts. For example, if a trader wanted to speculate on 10 crude oil contracts-- that's only 10,000 barrels-- that's not a lot of volume, per se. They would have to put $51,000 in a margin account before they could even get started.
Here is the symbol breakdown. When you look at futures screens, or if you see the prices reported in the Wall Street Journal or any other type of publication, you'll see these funny symbols. The first two letters of the symbol represent the energy commodity themselves. So CL represents crude oil. The second letter is the actual month of delivery. For example, U equals September. The final symbol is the number that corresponds to the year. In our example, 2. So the September 2012 contract for crude oil on the NYMEX is expressed as CLU2.
Other symbols that represent energy commodities-- NG for natural gas, HO for heating oil. RBOB represents unleaded gasoline, and then PN for propane. And then here's the breakdown of the symbols for the months that they use. Feel free to use this as a cheat sheet if you ever run across those quotes and can't remember what they mean.
When you look at futures screens, you're going to see column headers that will use these types of terms. When you see the open, that's the opening price at the opening bell. When you see people on television ringing the bell for the open of whatever market it might be-- the stock market, the NYMEX, the Chicago Mercantile Exchange-- as soon as the bell goes off, the very first trade that is consummated, that price is registered as the open for the day.
The high is the highest price that traded that day, including the after-hours electronic trading. The low is the lowest price that traded for that day, including after-hours electronic trading. That gives us the range on the day-- what was the entire range of pricing that day.
When you see last, that's the last trade that just occurred. In other words, what was the last trade that had occurred? The net would be the change in price from that last trade to the one prior to it. So are we going up or are we going down as we're trading currently? And then change-- the change is the change in price from the trade that just occurred, from that last trade, versus the prior day's settlement. What was the final price for the energy commodity the day before, and where do we sit relative to that today? That's what change represents.
We refer to futures contract trading as a zero-sum game. For every buyer, there is a seller. I can't buy crude oil contracts without someone being willing to sell them to me, nor can I sell them without a market. And believe it or not, less than 2% of all the contracts traded actually go to physical delivery. In other words, less than 2% of the contracts will actually be energy commodities exchanged between counterparties. Now, on the one hand, that may sound like a small number, but with each crude oil contract representing 1,000 barrels, and you can trade between 50,000 and 100,000 contracts a day, it does amount to a substantial amount of physical energy commodities being exchanged.
This is what a typical futures screen would look like. These are the headers that I mentioned to you. On the day that I printed this off, you can see the last trade was $92.68 and, represented a drop of $0.19 from the prior day's settle of $92.87 in the far right corner there. We had the opening price of $93.25, and a high and low on the day as well. And the very far right column is the time at which the trade occurred.
Natural gas futures contracts. The contract unit is 10,000 MMBtus-- that is, 10,000 million British thermal units. Prices are quoted in US dollars and cents, and the minimum fluctuation between trades has to be 1/10 of a penny or what we refer to as a tick. Trading hours are exactly the same, but the trading months for natural gas-- you can actually trade natural gas out 12 years if there was, in fact, a need to buy or sell for that long of a period of time.
Last trading day for natural gas contracts, the futures, is the third business day prior to the first calendar day of the delivery month. We do trade options in energy futures contracts. In the case of natural gas, those expire one day prior to the actual contract itself.
The delivery point for buying and selling under NYMEX natural gas contracts is a place known as the Henry Hub in Erath, Louisiana. Texaco has their Henry plant in Erath, Louisiana. Sabine Pipeline Company runs the hub on behalf of the New York Mercantile Exchange. And again, the delivery period is to be uniform across the month of production for which the contracts were exchanged.
This is a schematic of the pipelines going in and out of the Henry Hub. There are various sources of natural gas coming offshore, onshore. There is gas moving to the Northeast, the Southeast, the Upper Midwest, as well as from Louisiana back into Texas. So it made an ideal market hub for indicating various supply and demand.
Settlement price. Every day, the New York Mercantile Exchange will put together a final price for that day's trading. The settlement price is the weighted average of all the trades that occur during the last two minutes of trading in that regular session. Now, when the closest future month, or what we call the prompt month, when that contract expires, they're going to take the total number of trades in the last 30 minutes to come up with a weighted average, and that will be the price for that month. And that month rolls off, as we say, and it's in the history books.
Margin requirements for natural gas are substantially less than crude oil, but the value is substantially less, so there's only $2,100 margin requirement per contract.
This is what a natural gas futures screen would look like. If you ever see one of these on a trading floor or somewhere else, perhaps on someone's screen who trades in these contracts, this is what it would look like.
We're now going to talk about unleaded gasoline, referred to as RBOB. RBOB stands for Reformulated Blend for Oxygenated Blending. What we get at the gas pump-- you usually have the opportunity to get 100% unleaded in very few places. Mostly, it's a 90/10-- that is, it's 90% gasoline, 10% ethanol or some other type of blending component. In some cases, you hear about E85, which is 85% unleaded, 15% of some other additive, normally something like ethanol.
So what's traded on the New York Mercantile Exchange is actually the 100% unleaded. It becomes a feedstock for unleaded because it's only 90% of what we get at the pump unless we're buying 100% unleaded. So it's reformulated blend for oxygenated blending. They're going to blend oxygenators into the unleaded gasoline.
The oxygenators are seasonal in nature, depending on the regions. Again, oxygenators help to burn the gasoline more efficiently and therefore reduce the emissions. Oxygenators are things such as ethane, ethanol, butane, isobutane, and natural gasolines.
Every RBOB contract is 42,000 gallons. US dollars and cents, and the minimum fluctuation is 1/1000 of a penny per gallon. The delivery point is free onboard or delivered into the petroleum products terminals in New York Harbor. Margin requirements-- $8,100 per contract.
Last but not least, heating oil, or HO. It's sometimes referred to as number two fuel oil. Every contract is 42,000 gallons. We are still dealing with US dollars and cents per barrel. Minimum price fluctuation is 1/1000 of a penny per gallon. The delivery point is the same as for RBOB, and that is free onboard or delivered to the petroleum products terminals in New York Harbor. Everything else pretty much remains the same under the standardized NYMEX contracts.