In 2008, the price of crude oil on the New York Mercantile Exchange (NYMEX) hit an all-time high of $147 per barrel. And, within (6) months, the price had fallen to about $35. Again, in 2014, oil was over $100/Bbl in June only to fall to below $50/Bbl by December. While many factors led to these "peaks and troughs, the nature of futures trading and the exchange itself made this possible. The New York Mercantile Exchange has been around since the late 1800s. Financial energy commodity contracts, such as futures contracts, are traded on the New York Mercantile Exchange, and it is still the most influential financial energy commodities exchange in the world. Futures contracts are financial tools to hedge against the price fluctuations. In this lesson, we will explore the history of the exchange, how it functions, who participates, what commodities are traded and futures contracts. In this lesson, we will also learn about the NYMEX order flow. Standardized Order Forms are used on the floor of the NYMEX during order execution. All orders placed on the NYMEX to buy or sell contracts are done in a very precise manner where each party involved is fully aware of the details of the transaction.
At the successful completion of this lesson, students should be able to:
This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time.
If you have any questions, please post them to our General Course Questions discussion forum (not email), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.
Please take some time to review the optional materials. They will give you context for the rest of the lesson.
Financial energy commodity contracts are traded on the New York Mercantile Exchange (NYMEX). The New York Mercantile Exchange building is located on the Hudson River in New York City and owned and operated by CME Group of Chicago (Chicago Mercantile Exchange & Chicago Board of Trade). NYMEX has offices in other cities as well (Boston, Washington, Atlanta, San Francisco, Dubai, London, and Tokyo.) The New York Mercantile Exchange [4] 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, the New York Mercantile Exchange.
Later products would include yellow globe onions, apples, potatoes, plywood, and platinum. Platinum is the only one of these products which is still traded today on the New York Mercantile Exchange. Today, it trades crude oil, heating oil, gasoline, propane, natural gas, platinum, and palladium.
For a quick overview of the Exchange, view this "This is NYMEX" video (2:20 minutes).
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.
Here are the links to the crude oil [5]and natural gas [6] features in NYMEX. These links take you to the crude oil futures quotes [7] and natural gas futures quotes [8]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.
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 [9], 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.
Remember from microeconomics [10]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.
Figure 1 displays the NYMEX building located on the Hudson River in New York City and the NYMEX trading floor, where all the trades occur. Watch the video lecture at the bottom of this page to learn more about the NYMEX futures contracts.
While watching the Mini-Lecture, keep in mind the following key points and questions:
The following video lecture is 20:30 minutes long.
The lecture notes can be found in the Lesson 3 module in Canvas (Lesson 3: The New York Mercantile Exchange (NYMEX) & Energy Contracts.)
As explained in the video, “ask” is a motion to sell and “bid” is a motion to buy at a specific price. We use the word motion because the traders use hand signals to communicate to one another across the pits. The following video illustrates some of these hand signals. Please watch the 3:37 minute video, Trading Pit Hand Signals [13] below.
All orders placed on the NYMEX to buy or sell contracts are done in a very precise manner with each party involved fully aware of the details of the transaction. As legally-binding agreements, non-performance under a futures contract can have severe financial and legal consequences. Therefore, most phone conversations are taped to ensure the accuracy of the orders placed as well as the results of the execution of those orders. Standardized order forms are used during order execution and daily "check-outs" occur between brokers and their clients for verification of all trades conducted that day. In this section, we will follow a natural gas futures contract trade from the beginning to end for a producer and end-user wishing to lock-in a fixed price for a 12-month period.
While watching the mini-lecture, keep in mind the following key points and questions:
The following video is 10:40 minutes long.
"High Frequency Traders" (HFT) are impacting the market in a huge way by using super-computers to execute high volumes in nano-seconds. To get an explanation of HFT and their impact on the market, view this video (2:29 minutes).
Please watch the following short video (1:55) about the future of the NYMEX trading floor and how electronic trading is affecting the trading pits.
Now that we are familiar with the workings of the Exchange and futures contracts, we will walk through the cash market and its relationship to the financial market in the next lesson.
You have reached the end of Lesson 3. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there before beginning the next lesson.
Links
[1] http://onlinelibrary.wiley.com/doi/10.1002/9781119200727.app1/pdf
[2] https://www.investopedia.com/terms/f/futurescontract.asp
[3] https://www.e-education.psu.edu/ebf301/sites/www.e-education.psu.edu.ebf301/files/Transcripts/Lesson3_Transcripts/What%20are%20Futures%20Transcript.docx
[4] http://www.cmegroup.com/company/history/timeline-of-achievements.html
[5] http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude_contract_specifications.html
[6] http://www.cmegroup.com/trading/energy/natural-gas/natural-gas_contract_specifications.html
[7] http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html
[8] http://www.cmegroup.com/trading/energy/natural-gas/natural-gas.html
[9] http://www.cmegroup.com/
[10] https://www.e-education.psu.edu/ebf200/node/192
[11] http://www.futures101.ru/wp-content/uploads/2011/04/nymex-bld.jpg
[12] http://www.energymaxout.com/wp-content/uploads/2013/07/Oil-Trading-and-Speculation.jpg
[13] https://youtu.be/yd31eEEWOoc