Futures contracts (watch the video 1:37) are financial tools to hedge against the price fluctuations. Producers and consumers can use futures contracts to lock the price of a commodity in the future and let the speculators and traders trade the contracts (we will learn this in lesson 7). Consequently, producers and consumers are hedged against the price change and the risk is transferred to the traders and speculators. Traders and speculators bet on the price movements and gain or lose regarding the price behavior. Note that a contact has two sides, and when a trader wants to sell the contract, there has to be a buyer and vice versa. Trading futures contracts is a zero-sum game. If a trader gains profit, the other trader has to lose.
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 contractual obligation with the New York Mercantile Exchange, there are both financial and legal ramifications.
The components of a standard NYMEX energy contract are as follows.
- the name of the commodity and exact specifications of the commodity (for example WTI crude oil, natural gas, heating oil, unleaded gasoline;
- the quantity and volume of the commodity (for example 1,000 barrels for the crude oil futures contract);
- the price, is determined by the market and is normally what we are most interested in;
- the location that the commodity has to be delivered;
- and then the date, the date that the commodity has to be delivered. At what future point in time do we wish to buy or sell the energy commodity?
Here are the links to the crude oil and natural gas features in NYMEX. These links take you to the crude oil futures quotes and natural gas futures quotes in NYMEX. You can click on the “About This Report” at the bottom right of the table to find the column head explanations. Reported information in the table will be explained later in this lesson.
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.
Functions of Energy Contracts
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 at 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 find the commodity prices. Under the "Trading" tab, you can find the commodity and then the commodity futures contract.
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.
Futures Market Characteristics
Remember from microeconomics that a perfectly competitive market has the following characteristics: 1) Nobody has market power 2) Product is homogeneous 3) Information is perfect and 4) There is no barrier to enter and exit. Indeed, such a hypothetical market with all these characteristics doesn’t exist in the real world. However, the futures market is one of the closest markets to the perfect competition. There are many buyers and sellers. There is no or very limited government intervention in this market. There is no significant barrier to enter and exit the market, except the legal and financial responsibility of market participants. Traded products are futures contracts that are standard and homogenous for each commodity. In addition to these, cost of information is relatively low. All these features make the futures market an efficient market. And from microeconomics, we know that in an efficient market 1) price is determined by the market dynamics, 2) price represents the true value of the good, and 3) price fluctuates around the true value of the good. These happen because the futures market is highly related to the cash market. A portion (even though it’s a very small portion) of the futures contracts ends in actual delivery.
Note that an important feature of the futures contracts is, gains and losses to each party is settled every day. This is called marking to market or daily settlement. It’s equivalent to closing the contract each day and opening another one for the next day. When opening the position, either long or short, each party only pays a small amount of money, which called margin requirement. The margin is used for daily gain or loss (daily settlements) due to the price changes. And if the loss is more than amount in the margin account, the party has to immediately deposit more money into the account.
The following lecture will take you through the history of the NYMEX, the type of trading that occurs ("pit" vs. electronic), the major players, the commodities traded, and futures contract specifications.