What are Oil Futures Contracts?

Oil futures contracts are financial contracts that carry two legally binding obligations. The buyer of the contract is obliged to take delivery and the seller is obliged to make delivery of the underlying asset (in this case oil), at a future settlement date.

Most Crude oil futures contracts are traded on the New York Mercantile Exchange (NYMEX) where West Texas Intermediate (WTI) oil is traded and the Intercontinental Exchange (ICE) based in London where Brent crude oil is traded.

Oil futures contracts are predominantly traded through electronic dealing systems, however the old fashioned open outcry system is still used on some exchanges.

How are oil futures traded?

In order to place a trade you have to be a member of one of these exchanges. Exchange members can either trade their own accounts or can choose to execute orders for others. In this case the exchange member is acting as broker and will require a fee for his services.

The Role of the Clearing House

Most futures exchanges also operate a clearing house which ensures that trades are settled in accordance with market regulations.

In UK markets, the independent London Clearing House (LCH) is used to clear business for many different exchanges. The ICE exchange is also recognized as a clearing house by the UK regulator, the Consumer Protection and Markets Authority (CPMA).

In the US, the NYMEX exchange operates its own clearing house which is regulated by the Commodity Futures Trading Commission (CFTC). When the buyer and seller agree to trade futures contracts, their transaction is recorded and the clearing house steps in to officiate the trade, in effect breaking the ‘bond’ between the buyer and the seller. This process is called ‘novation’.

Clearing houses are primarily responsible for the management of risk on each transaction – they establish both margin levels and default rules as well as ensuring each contract is settled.

When you buy a futures contract, you don’t have to put up the full value of each contract. You only have to pay an initial margin that acts like an insurance policy (the amount of margin you have to put up is determined by the clearing house).

When the contract closes, the buyer and seller are obliged to either make or take delivery of the underlying asset. In the case of oil, settlement can be carried out in one of two ways: You can either take delivery of the oil into a predefined location (not very practical) or take a cash settlement.

On the NYMEX exchange, physical delivery is possible into the oil hub of Cushing, Oklahoma. ICE Brent crude contracts on the other hand have no physical delivery option.

In the real world physical delivery doesn’t take place very often. Positions are often closed early by taking an offsetting position for an opposite amount of contracts.

So who decides the price of oil? 

You may be under the illusion that the oil price is determined by traditional market forces. But nothing could be further from the truth.

As much as 60% of today’s crude oil price can be attributed to speculation driven by large investment banks and hedge fund managers. Market forces have little or nothing to do with it.

The international oil exchanges play a crucial role in this game of cat and mouse. The New York Mercantile Exchange NYMEX and the Intercontinental Exchange ICE in London control global crude oil prices.

The ICE exchange in London trades what are called Brent futures which represent most of the crude oil produced in Europe and North Africa.  Major oil producing nations such as Russia and Nigeria use Brent as a benchmark for pricing the crude they produce.

The WTI is used as a barometer for the key US crude oil market. It’s not only used to price oil traded in the U.S, but is a key benchmark for US production.

You don’t have to be a member of a trading firm to participate in this lucrative market. You can get involved yourself by joining a broker that’s a member of one of these exchanges. If you’re a US based trader optionsXpress is a good choice, as they’ll give you access to both exchanges from one trading platform.

Oil Futures Manipulation

With recent fluctuations in the oil market, it’s not surprising that price manipulation has become a bone of contention. In times gone by participants in the oil market actually had a use for the end product.

Today speculators dominate the market, their only aim is to make money, therefore manipulating the price becomes part of the game. The problem is, you the consumer end up paying for it.

Who Regulates Oil Futures?

Oil futures are regulated in the U.S by the Commodity Futures Trading Commission (CFTC), whose job it is to monitor oil price movements and futures contracts. They also set limits on how many individual contracts each market participant can own.

Flouting of these rules is a federal offence and can result in large fines and even jail. But that doesn’t stop people trying. The question is how much fraudulent activity is being carried out?

How Can the Price of Oil Be Manipulated?

The manipulation of commodities markets isn’t something you can do on your own. The market is simply too large for any one person to have an effect. Besides that the CFTC regulates the number of contracts any individual or firm can own at any one time.

No, manipulators are usually trading firms that work together to buy up large quantities of stock when they know supply is limited. By withholding oil off the market, these companies seek to artificially inflate the price of oil whilst simultaneously making large bets that the price of oil will fall.

Eventually, when they release the oil that they’re holding they make a small loss, but it doesn’t matter to them because they make vastly more when their short contracts get exercised.

Actions like this are only possible if you have inside knowledge from others within the industry. It’s difficult for a trader in London or New York to know exactly what’s going on at the pump head in Azerbaijan for instance. So traders maintain contacts on the ground to help them get an understanding of the current supply situation.

This inside information can be coupled with news events, like the disruption of a pipeline or port blockade. But in instances like this there are likely a lot of speculators predicting a disruption to supplies and therefore it will be much harder to obtain a significant holding.

Inside information is preferable, because it’s much easier to control supplies when the market is slow and the number of buyers is weak, than to fight against the rush of a bull market.

What Effect Does Oil Manipulation Have?

Manipulating the price of oil is very damaging to the economy. We’ve all seen how increased oil prices affect our daily lives, fuel becomes more expensive, your grocery bill goes up and airline fares increase.

So is oil price manipulation going to go away? Not any time soon, there’ll always be people who care more about increasing their own wealth than about the state of the economy as a whole. Why would someone sunning themselves in the Bahamas care about a struggling working class family in Michigan.

It’s up to the government to stamp it out. There are signs they’re starting to take it more seriously, but you can bet that the vast majority of oil price manipulation still goes unnoticed.

The Importance of Oil Futures

With all this turmoil in the markets and speculators driving up prices, some people think it would be better to do away with oil futures altogether and trade oil direct, unfortunately this doesn’t work in practice. It’s a sad fact that the vast majority of oil reserves are kept in some of the most unstable regimes on earth, think Iraq and Iran.

The net result is that stable supplies can never be guaranteed. Price fluctuations will still happen it’s just that companies will have no way of hedging against them. Lets look at the last 30 years of oil prices to get a better idea of how natural disasters and war affects prices.

Oil Futures History – 1980-90

At the start of the 80s President Reagan was halfway through his first term and oil futures were trading at $30.50 per barrel. Oil remained stable within this period despite the cold war, eventually dropping as low as $11.11 in July 1986.

In August 1990 the first Gulf War caused a spike in oil futures that saw the price rise from around $20 to over $39 per barrel in about 10 weeks. The spike was short lived however and oil futures were back below $20 by February of 1991. The average price throughout the 1990’s was around $20 per barrel. The price dropped back below $15 for a few months in 1998 and closed out the century in 1999 at $26.31.

Oil Futures History – 2000 – Present Day

Despite more unrest in the Middle East oil futures remained stable in the early part of 2000, trading within the $25 to $35 range. In May 2004 the $40 level was finally breached; this was the start of a run that resulted in record prices being set year after year until May 2008.

Oil prices peaked at $145.29 on July 3, 2008. Then the bubble burst and the price dropped back under $100. In October 2008 oil futures were trading at under $40 per barrel. In early 2009 oil futures started to steadily climb back up to $75 and the first nine months of 2010 saw prices reach the low $80’s. By early 2012 WTI futures were trading just below $100.

Who’s really responsible for The Rise in Oil Prices?

Ask the average American who’s responsible for the high price of oil and you’ll get a few different answers. The recent unrest in Libya and increased consumption in China will be amongst the most popular, a few people might say its OPEC deliberately keeping supplies tight and therefore the price high.

The truth is that whilst all the above factors do have an affect, they’re not responsible for the vast majority of the current price increase.

The biggest culprits are speculators who game the futures markets for no other reason than to line their own pockets. Who are these speculators? Well they could be anyone, even you. Although, unless you have significant cash reserves you’re unlikely to have an affect on your own.

But collectively, these speculative trades add up. Together it’s reported that up to 95% of the oil futures traded each day are speculative. Each and every one of those traders expects to make a profit in the process.

You don’t need to be a rocket scientist to realize what affect that has on world oil prices. The effect is doubly damaging when you realize that those traders who have a legitimate use for the oil, like airlines and petrochemical companies are forced to buy oil at these inflated prices just to maintain their business.

What Can Be Done About It?

In the short term there’s not a lot that can be done, any change would have to be implemented by the government and their hands are tied because they have to allow for a free market.

Outright manipulation of the oil price is already outlawed and punishable by large fines and imprisonment. But speculation by hedge funds, large banks and small speculators is here to stay, along with the overly inflated oil price. So since this problem isn’t going to go away, what can you do about it?

Well there’s nothing to stop you learning how to trade oil options and getting in on the action yourself. As a small player you’re not going to have much of an affect on your own, but the profits you make should cover the extra cost of living that increased oil prices cause.

Learn How To Trade Oil

Learning how to trade oil options and futures is actually quite easy. We have plenty of articles for you to read and you should also check out optionsXpress who have an excellent rage of trading tutorials to help you get started. They’ll also give you a virtual $25,000 to try out a few trades without having to risk any of your hard earned cash.

If you’re looking to trade oil futures for the first time and you’ve come from a world of stocks and shares, then oil futures might seem a little confusing at first.

It’s not helped by the fact there are numerous oil futures contracts that can be traded on a number of different exchanges. But don’t worry they’re actually really easy to understand.

First of all let’s look at the different contracts that are available. In the Table below you’ll find all the current oil futures contracts that can be traded on both the New York Mercantile Exchange (NYMEX) and the International Petroleum Exchange (IPE).

Oil Futures Symbol Exchange
WTI Crude Oil (light sweet) CL NYMEX
Crude Oil access CLA NYMEX
Sour Crude Oil SC NYMEX
Brent Crude Oil BZ NYMEX
Heating Oil No.2 HO NYMEX
Heating Oil No.2 access HOA NYMEX
Oman Crude Oil Swap Futures DOO NYMEX
Brent vs. Oman Crude Swap DBO NYMEX
DME Oman Crude Oil Ave DOA NYMEX
Brent Crude Oil LO IPE
Gas Oil QS IPE

The table above shows the individual symbols for each options contract and the exchange it’s traded on.

Every oil market has a ticker symbol that’s followed by symbols for the contract month and year.

Let’s take a look at an example. A sour crude oil contract with a March 2012 expiry would have the ticker symbol SCH12.

The “SC” is the underlying contract.
The “H” represents March.(F=Jan, G=Feb, H=Mar, J=Apr, K=May, M=June, N=July, Q=Aug, U=Sep, V=Oct, X=Nov, Z=Dec)
And the “12” represents the year – 2012.

Brent crude oil futures are a little more complex because Brent crude can be traded on both the IPE and NYMEX, so it has two different symbols for each exchange.

Whats The Difference Between Oil Options & Futures?

Crude Oil Futures?

Crude Oil futures are exchange traded contracts where the contract buyer agrees to take delivery from the contract seller, a specific amount of crude oil (eg. 3000 barrels) at a predetermined price on a future delivery date.

Crude Oil Futures Trade Example

Let’s say you think that the price of oil is undervalued, so you take out 1 month NYMEX Brent Crude Oil Futures contract at $44.20 per barrel. Since each contract represents 1000 barrels of oil, the value of the contract is $44,200. However, instead of paying the full value of the contract, you’ll only be required to deposit an initial margin of $12,825 to open the position.

One week later, the price of crude oil has risen to $48.62 per barrel. Each contract is now worth $48,620. So by selling your contract, you could exit your position with a net profit of $4,420.

Crude Oil Options

Crude Oil options are option contracts in which the underlying asset is a crude oil futures contract not the crude oil itself.

The holder of the option possesses the right, but not the obligation to assume a long or a short position in the underlying crude oil futures at the strike price.

This right will cease to exist once the option expires.

Call Option Example

Let’s say Crude Oil is currently trading at a price of $38.00 per barrel. A NYMEX call option with a strike price of $42.00 is priced at $2.89 per barrel. Each NYMEX Crude Oil futures contract consists of 1000 barrels of oil, so the amount you have to pay to trade the option is $2,890.

Upon expiration, the price of crude oil has risen by 20% and is currently trading at $45.60 per barrel. To realize your profit you’d need to open a long position in the underlying market at a strike price of $42.00. This means you effectively buy the underlying crude oil at only $42.00 per barrel on closing day.

If you want to close this trade you’d have to buy an offsetting short futures contract at the market price of $45.60, resulting in a profit of $7.60 per barrel.

However you don’t have to wait for the option to expire; you could simply sell it back to the market prior to expiry to realize your profit.

Trading Indicators

Before you start trading there are a few indicators you can use to determine which direction the price is heading. I’ve covered two of the most popular below. You can use these indicators to get an understanding of the current trend and spot profitable breakouts.

Oil Futures Volume

The volume signal on a commodities chart is one of the most misunderstood technical indicators. I can think of only a few situations when it’s actually useful, in fact you could trade futures profitably without ever looking at it! So why should you bother learning about it? Well it  just so happens that those few times can prove to be very profitable.

Firstly, what exactly is volume?

We’ve all heard of volume right, you find it everywhere from your TV to your iPhone. But what does it mean? Well in commodities, volume refers to how much noise there is in the market or to put it another way, how many oil futures contracts have been traded during a given time period.

Usually plotted as a histogram, volume represents the interest level in a particular commodity. If the volume is low, buyers and sellers are hard to come by. If on the other hand the volume is high it means buyers and sellers are everywhere.

The added benefit to this is that it shows you the amount of liquidity in the market. Liquidity simply refers to how easy it is to get in and out of the trade.

If oil is trading on low volume, there aren’t many traders involved and it would be more difficult to find a trader to buy from or sell to. In this case, you would call the market illiquid.

If oil is trading on high volume, then there are many traders involved and it would be easier to find a trader to buy from or sell to. This is called a liquid market.

Most traders however mistakenly believe that stocks trading on high volume means there are more buyers than sellers.  This is wrong! Regardless if it’s a high volume day or a low volume day there’s still a buyer for every seller.

Volume and Price

So if volume only represents the level of interest in the commodity, when is it useful?

Expansion of range and high volume – If the oil price is staying within a narrow range and then suddenly breaks out with an increase in both range and volume, this is a sign that there’s increased interest in the stock and it will in all probability continue higher.

Narrow range and high volume – If on the other hand the oil price has very high volume but the range is narrow, significant accumulation or distribution is taking place. Ever heard the saying, “volume precedes price”?

Sometimes you’ll see volume increase before a significant move in the oil price. Look for volume to move higher than the previous day. This is a sign that there might be a significant move ahead.

Dollar and Oil Futures Correlation

There’s strong correlation between the USD and the price of crude oil futures. This is hardly surprising considering the vital part oil plays in the modern economy.

But how does that correlation manifest itself and how can you use it to your advantage? Let’s look at this correlation in more detail, that way you’ll be able to profit from these various scenarios as and when they present themselves.

USD Oil Price Correlation

Why is There Correlation in The First Place?

A weak dollar makes oil cheaper to buy from a non U.S. buyer’s point of view. From non U.S. investor’s perspective, it would be better to buy oil when it’s cheaper. This has the effect of driving high demand outside the US. causing the price of oil to rise.

Let’s look at an example, say oil is trading at $100 per barrel and the EUR/USD is trading at 1.3370. So it costs you €74.79 to buy that $100 barrel. When the dollar gets devalued the Euro appreciates.

So what if the value of the EUR appreciates by 10 percent to 1.4700. That means you can now buy that same $100 barrel of oil with only €68 Euros. This lower price outside the U.S results in increased demand from abroad and the price of oil rises as the available supplies are depleted.

So the correlation between the price of crude oil and the U.S. Dollar is no coincidence. The question is how do you take advantage of it?

How to Trade U.S. Dollar and Oil Futures Correlation

There’s lots of times throughout a typical trading day when the dollar begins to move more aggressively, such as the open of U.S. Markets, before and after major news events such as Jobless Claims Reports or FOMC News.

You need to watch for crude oil prices moving in the opposite direction to that of the dollar. When the Dollar is trending, look for breakouts to occur. With the dollar in a up trend, you need to look to enter a short Crude Oil Futures contract.

Traders will often use the Dollar/Oil correlation as a filter because it allows them to avoid high-risk entries. If the U.S. Dollar is not trending, Crude Oil Futures tend to reverse their current trend quite quickly. The U.S. dollar has a tendency to whipsaw up and down when the market is indecisive, don’t be tempted to risk trading Crude Oil futures when the market is indecisive.

If you’re smart you’ll wait for the correlation to appear before placing a trade.

Heating Oil Futures

Of course there are many different types of oil, you don’t have to limit yourself to trading Crude Oil, other forms of oil can prove to be just as profitable. Heating Oil futures for example are typically offer great profit potential whilst offering much lower volatility.

Heating oil chart

How to Trade Heating Oil Futures

Let’s say there’s been a cold spell and you think the price of heating oil will rise due to increased consumption, you can profit from this by taking a long position in the underlying futures market.

Heating Oil Futures Trade Example

The current price of a NYMEX Heating Oil contract is $1.477 per gallon. Each futures contract represents 42000 gallons of heating oil, so the contract represents a value of $62,034. However due to margin requirements, you’ll only have to deposit around $10,000 to open the position.

Fast forward seven days and the price of heating oil has risen to $1.685 per gallon. Your contract is now worth $70,770. So by selling your contract you’d realize a profit of $8,736.

Margin Requirements

In the example above, heating oil prices have risen by around 15%, but the ROI is around 80%. This possible because of the amount of margin that’s required to enter the trade (typically around 16%).

However you need to be careful trading on margin, if the above trade had turned sour, you would have had to deposit more money into your account to maintain the minimum margin requirements, otherwise your trade will be closed immediately.

To Sum Up

Trading crude oil contracts is certainly not easy but with a little patience and a lot of practice you should be able to master it. One of the key choices you must make early on is choosing the right broker, you must choose a broker that works with you not against you.

I’ve found one of the most reliable brokers to choose when you’re just starting out is optionsXpress, because they offer some of the best futures and options training around and also give you access to a virtual trading account for you to practice with.

Like I said practice makes perfect so it’s best to use someone else’s money than burning through your own. And don’t underestimate just how much you’ll have to go through before you’ve mastered the art of futures trading.