EME 801
Energy Markets, Policy, and Regulation

Futures Markets for Crude Oil


Futures Markets for Crude Oil

Not much has been made here of long-term contracts for oil. This is because up until the early 1980s there were not very many. Production continued as long as the extracted oil could find a home in the spot market. The oil-producing countries, recognizing their market power, either implicitly or explicitly avoided long-term contracts in pursuit of volatile and largely lucrative spot prices.

Following the oil crisis of 1979, the market seemed to have had enough of OPEC's games. Non-OPEC crude production increased as new fields were opened up in Alaska and the U.K., where there was a healthy forward market for Brent crude oil. The New York Mercantile Exchange (NYMEX) officially opened its doors to oil trading in 1983, although the exchange had started selling product futures some years before. Forward markets arose because while the spot market was good for the OPEC governments, it was lousy for oil companies, refiners, and other government buyers. Although the number of these buyers was still relatively small, they needed a way to hedge the spot market, and traders were the means to this end.

We have already explained the difference between spot markets and forward markets. Both are "physical" markets, in that their main purpose is to exchange commodities between willing buyers and sellers. A spot or forward transaction typically involves the exchange of money for a physical commodity. Within the past few decades, entities with sufficiently large exposure in the physical market (i.e., the need to buy or sell lots of physical barrels of crude oil) have developed financial instruments that can help them "hedge" or control price volatility. By far the most important of these financial instruments is the "futures" contract.

Futures contracts differ from forward contracts in three important ways. First, futures contracts are highly standardized and non-customizable. The NYMEX futures contract is very tightly defined, in terms of the quantity and quality of oil that makes up a single contract, the delivery location and the prescribed date of delivery. Forward contracts are crafted between a willing buyer and seller and can include whatever terms are mutually agreeable. Second, futures contracts are traded through financial exchanges instead of in one-on-one or "bilateral" transactions. A futures contract for crude oil can be purchased on the NYMEX exchange and nowhere else. Third, futures contracts are typically "financial" in that the contract is settled in cash instead of through delivery of the commodity.

A simple example will illustrate the difference. Suppose I sign a forward contract for crude oil with my neighbor, where she agrees to deliver 100 barrels of crude oil to me in one month, for \$50 per barrel. A month from now arrives and my neighbor parks a big truck in my front yard, unloads the barrels, and collects $5000 from me. This is a "physical" transaction. If I were to sign a futures contract with my neighbor, then in one month instead of dropping off 100 barrels of crude oil in front of my house, she pays me the value of that crude oil according to the contract (this is called "settlement" rather than "delivery"). So, I would receive $5000. I could then go and buy 100 barrels of crude oil on the spot market. If the price of crude oil on the spot market was less than $50 per barrel, then in the end I would have made money. If it was more than $50 per barrel, then in the end I would have lost money, but not as much as if I had not signed the futures contract.

This simple example illustrates the primary usefulness of futures contracts, which is hedging against future fluctuations in the spot price. A hedge can be thought of as an insurance policy that partially protects against large swings in the crude oil price.

NYMEX (now called the "CME Group") provides a platform for buying and selling crude oil contracts from one month in advance up to eight and a half years forward. The time series of futures prices on a given date is called the "forward curve," and represents the best expectations of the market (on a specific date) as to where the market will go. Figure 1.5 shows an example of the "forward curve" for crude oil traded on the NYMEX platform. (Note that the data in this figure is dated, and is just for illustration - you'll get your hands dirty with more recent data soon enough.) The value of these expectations, naturally, depends on the number of market participants or "liquidity." For example, on a typical day, there are many thousands of crude oil futures contracts traded for delivery or settlement one month in advance. On the other hand, there may be only a few (if any) futures contracts traded for delivery or settlement eight years in advance.

The NYMEX crude oil futures contract involves the buying and selling of oil at a specific location in the North American oil pipeline network. This location, in Cushing Oklahoma, was chosen very specifically because of the amount of oil storage capacity located there and the interconnections to pipelines serving virtually all of the United States. You can read more about the Cushing oil hub in the Lesson 1 Module on Canvas, but it is one of the most important locations in the global energy market.

There is a wealth of data out there on crude oil markets. The following two videos will help orient you towards two websites where you can find information on crude oil prices, demand, shipments and other data. The first covers the NYMEX crude oil futures contract and the second covers the section on crude oil from the U.S. Energy Information Administration. Although these are U.S. websites, there is a good amount of data on global markets.

Video: Crude Oil Futures (4:01)

Video: Crude Oil Futures Video
Click for a transcript of the Crude Oil Futures video.

Many of the world's most active energy commodity markets are run by an organization called the CME Group. And in this video, I'm gonna show you the CME group's website and show you how to find information on energy futures markets through the CME Group. And the specific example we're gonna use in this video is how to find information about the futures market for West Texas Intermediate Crude Oil, which is the benchmark crude oil futures market. So we're gonna go to the CME Group website, CME Group.com. And then we're gonna click on markets. And then in the section here where it says "browse by," we're going to click on energy. And then once we come to the energy futures and options page, we're going to click on "Products." And this will take us further down the page to where we can find information on a number of different energy futures markets. The one we're most interested in right now is crude oil futures. What we're going to click on that. And then it may take a second for the page to load. But what is going to pop up is a whole bunch of information about the futures market for West Texas Intermediate Crude Oil. And so I'll just say a little bit about what these different columns mean. The Month column is the month of contract delivery, not the month that the contract was treated. So September 2020, for example, that indicates the contract for deliveries of West Texas Intermediate crude oil in September 2020. The last column, the column that says "Last" here, that shows the last recorded offer for West Texas Intermediate Crude Oil in that month. It takes units of dollars per barrel. So here, the September 2020 contract, the last offer that was received is $42.78 per barrel. And the "Change" column is just the change, again, in dollars per barrel, from teh previous author. The "Prior settle" column is one that we'll use a lot. And that represents the last recorded price at which a buyer and a seller were matched at which to trade happened. And so here the prior subtle column for the September 2020 contract is $42.89 per barrel. The "Open" and "High" and "Low" columns, those show the price for the West Texas Intermediate Crude Oil Futures contract at the start of the trading day. And then the highest price and the lowest price where the crude oil contract traded on each day. Then the volume just shows you the number of contracts that have traded. And these orange flashes you see will happen because this data is effectively updated in real time. And so when there are additional contracts traded or when the price changes, those will show up in real time on the screen. So this video has shown you how to get to the CME group's website, where to find information on energy contracts, and specifically, how to get data on the West Texas Intermediate Crude Oil futures contract.

Video: EIA Oil (4:24) 

Video explaining how to navigate the US Energy Information Administration site.
Click for a transcript of EIA Oil video.

One of the best sources for energy information is the U.S. energy information administration or EIA, but navigating the page can be a little bit tricky and you kind of have to know exactly what you're looking for.

So, here what I'm going to do is introduce you to the EIA webpage in general and point out where to find information about crude oil and refined petroleum products. So, the EIA homepage is www.eia.gov, and when you go there you'll see several things. One is that they have a sort of rotating list of stories some of which you may find interesting. They have some specific data highlights for electricity or natural gas or oil, but if you're looking for something specific, generally the best place to start is this button at the top that says sources and uses. Once you click on that, you'll see basically all the information on the EIA website that is organized by energy source.

So, you have petroleum, coal, natural gas, electricity, and some others. So, for this I'm going to click on the petroleum and other liquids button and that will take you to the petroleum home page at the EIA where again they have some sort of rotating cover stories, and they also have some brief articles that that may be of interest and links to some of the EIA regular publications that are relevant to crude oil and refined petroleum products. If you really know what you're looking for, once you get to the petroleum home page the best place to go is this tab that says data. So, here, I'll click on that and from the data tab you can see the data that the EIA has on oil and petroleum products organized into several different categories. So, high level data, so things like national crude oil prices, national level crude oil production supply, are in this summary tab prices for crude oil and petroleum products are in the prices tab there are a lot of these.

You have reserves information on refining imports and exports and shipments between different parts of the United States and then a consumption data is a little, you have to look at this with a little bit of care, because when somebody sells oil or petroleum product to somebody else the seller doesn't actually know what the buyer is doing with it and so there's a difference between sales and consumption. So for example, when I put 10 gallons of gasoline in my tank, right, then what I'm basically doing is I'm buying gasoline, but I'm not using it at the same second that I bought it, and they use those 10 gallons within a week or if I don't drive very much it may take me months to use those ten gallons of gasoline. So, the EIA is very careful to talk about sales, so these would be sales on the wholesale or retail level. So, for example, sales of fuel oil and kerosene or terms that they call disposition or product supplied and what they mean by disposition and product supplied is simply the movement of crude oil from petroleum products from us for example, storage facilities, to retailing facilities or are retailing facilities to end use consumers.

Chart showing West Texas Intermediate Futures Prices dropping from $105 to $81 between Oct 13 and Dec 18. More info in text below
Figure 1.5: West Texas Intermediate Futures Prices.

If you look at Figure 1.5, you might notice that the price of crude oil generally declines as you move farther out into the future. This is called "backwardation." The opposite, in which the price of crude oil increases as you move farther out into the future, is called "contango." In general, we expect the crude oil market to be in backwardation most of the time; that is, we expect the future price to be lower than the current (spot) price. This can be true even if we expect demand for crude oil to increase in the future. Why would this be the case? If demand is expected to rise in the future, shouldn't that bring the market into contango?

Sometimes this does happen. Most often, the crude oil market is in backwardation because storing crude oil generally involves low costs and has some inherent value. Suppose you had a barrel of crude oil. You could sell it now, or store it to sell later (maybe the price will be higher). The benefit to storing the barrel of oil is the option to sell it at some future date, or keep on holding on to the barrel. This benefit is known as the "convenience yield." Now, suppose that hundreds of thousands of people were storing barrels of oil to sell one year from now. When one year comes, all those barrels of oil will flood the market, lowering the price (a barrel in the future is also worth less than a barrel today; a process called discounting that we will discuss in a later lesson). Thus, because inventories of crude oil are high, the market expects the price to fall in the future.

The ability to store oil implies that future events can impact spot prices. A known future supply disruption (such as the shuttering of an oil refinery for maintenance) will certainly impact the futures price for oil, but should also impact the spot price as inventories are built up or drawn down ahead of the refinery outage.

We'll close this discussion with a very interesting and entertaining thing that happened in the crude oil market in April 2020, when the price of oil on the futures market went negative, trading at -$37.63 per barrel. This means that if you were a potential buyer of crude oil, someone would have paid you $37.63 for every barrel of oil you agreed to buy. I don't know about you, but no one has ever paid me to fill my car's gas tank. It usually works the other way around. What on earth happened here? This short blog post from RBN Energy has a good explanation, and you can also watch RBN Energy's interview with Larry Cramer. The reason for this price craziness has to do a little bit with panic in the oil market because of the coronavirus pandemic and a little bit with how futures markets work. Basically, what happened was that there were a bunch of crude oil traders who had contracts to buy crude oil for delivery in May 2020. Those traders either had to take physical delivery of a bunch of barrels of crude oil in May, or find someone else to assume their contract (this is called "closing one's position" in commodity market parlance). Well, since the pandemic had hit and crude oil demand had collapsed, there was no one in the market who really wanted to buy crude oil off of these traders. And, there was no place for these traders to physically put their crude oil that they were obligated to take in May 2020. So these traders got caught in a market squeeze and had to pay others to close their positions. It's crazy, and hasn't happened in the crude oil market before...but it makes perfect sense when you realize how this market actually works!