Futures Contracts and NYMEX

Okay, let’s start reviewing what futures are, and before that, I will need to explain forward contracts first. So, forward contracts: let’s say on the left-hand side we have an oil-producing company, and on the right-hand side, we have a refinery which consumes oil and produces some refined products. So, on the left-hand side, we have a producer that sells the oil, and on the right-hand side, we have consumers that buy the oil.

Let’s say right now the refinery needs some crude oil, and the producer has some oil. They just sell and buy, and that’s it. Okay, but this is an ongoing business activity, right? The producer knows that for any time in the future, they know the production rate and how much crude oil they will have in the future. Also, the refinery, this is a continuous production process, they know they’re going to need crude oil for almost any time in the future, right? Both of these are concerned about market fluctuations, and they want to make sure they have a market for the produced crude oil or that they can have the crude oil they need. They are also concerned about the price. The producer is concerned that if the price drops, they’re going to lose money. On the other side, the refinery is concerned that if the price goes up, they’re going to lose money, and they want to hedge their risk against price fluctuations.

So, what they can do is negotiate a contract called a forward contract, and they can discuss three things: time, price, and quantity. Let’s say we are going to sign a contract that sometime in the future, let’s say in November, at the locked price of 50 dollars, the producer is going to deliver a specific quantity of crude oil, let’s say 5,000 barrels, to the refinery. So, they have a contract that locks the price for delivery at some time in the future, and they can have many of these. This is called a forward contract. By doing that, they first make sure the producer has a market for crude oil, and the consumer knows for sure they will have crude oil in November. Also, they know the price is locked. The price is locked at 50 dollars. The price doesn’t change.

Okay, what are the restrictions or limitations of these forward contracts?

First, let’s say these two entities, the producers and consumers, are not exactly the same size. Let’s say the refinery is very large, or the producer is a very large producer, and one of them is a lot smaller or larger than the other one. Then, they have to go and probably find 10 other counterparties to negotiate and sign the contract with each of them, and they have to do it for almost every month, and so on and so forth. It’s doable; it is still an ongoing activity in the financial market, but it’s not the most efficient way of doing it.

The other problem with this is, let’s say this contract is signed to deliver the crude oil in November, and the price is locked at 50 dollars. Let’s say a couple of months before November, the price of crude oil goes up to 60 dollars. If it goes to the market, it’s 60 dollars, but under this contract, it is locked at 50 dollars. Because it is locked, the producer loses money. If there was no contract, the producer could have sold it in the market at 60 dollars. So, the producer will get more and more upset, thinking, “Okay, I am losing money under this contract,” but there is no way they can cancel the contract. On the other side, if the price of crude oil starts going down, the producer is happy, but the consumer cannot cancel the contract and go and buy the cheaper oil in the market. They have to pay the 50 dollars locked price. So, the problem is: they cannot cancel the contract at all.

So, this is the kind of introduction to how there is a better, more efficient type of contract needed based on the forward, and that’s going to be called futures, which I’m going to explain in a bit.

Okay, now let’s make some changes and move toward that more efficient contract, which we’ll call futures later on. The first thing that we want to do is introduce a third party here. Let’s say we call this third party an exchange, a businessman, businesswoman, or a company. Instead of the producer going and trying to find consumers, these producers will just go and sign a contract with this third party. The consumer, the refinery, will also go and sign the contract with this third party. This solves the problem that they don’t need to go and find, let’s say, 10 more consumers and sign individual contracts with them.

Let’s make some more adjustments. Let’s say we make these contracts standard. You remember in the previous slide I said these forward contracts are case-based? They are signed for a specific case between these companies, and their contract terms are negotiated between these two entities.

Now let’s introduce a type of contract where all the terms are standard; there’s nothing negotiable. These are all fixed in place, and nobody can change them. The quantity is fixed, the delivery point is fixed, the price is fixed, which I’m going to talk about in a bit. Everything is fixed under these contracts, except the delivery date. The delivery date goes by the incremental month. It’s either January, February, March, and so on. The only difference between these contracts is the delivery date or expiration date. When we make these contracts exactly similar, there’s no need for any negotiation back and forth. We will have these standard contracts, and what we can do is have all the other entities join this market and trade these contracts.

So, we will end up with an exchange in the middle, which will have these contracts that are all standard, exactly the same. We have these players, the actual producer, the refinery, and the oil producer, who can also join as one of these players in the market. They can either buy these contracts or sell them. If they buy this contract, we say their position is long. If they sell this contract, their position is short.

If they buy the contract (long position), they have to take the delivered crude oil; they will receive the crude oil when the contract expires. On the other side, those players, those entities who sold the contract (short position), have to deliver the crude oil, the amount of crude oil, at the expiration date.

Because all these contracts are exactly the same, these are called futures. They have a fixed quantity of one thousand barrels of crude oil, the delivery point is fixed (Cushing, Oklahoma), and the spec is WTI (West Texas Intermediate), which is low sulfur, sweet crude oil. The expiration date goes by the month: January, February, March, and so on. The price is set by these trades, by these market movements, sell and buy, supply and demand. If somebody does not like the loss they are making based on the price movement, they can get out of the contract anytime they want. They don’t have to wait until the expiration date. If the prices are going up and the position is short, they can immediately close the position by buying back, by closing the position with the exchange.

The entities who are long these contracts, the entities who bought the contracts, will make money, will profit, when the price goes up. On the other side, if an entity has a short position, they will lose money. If the price starts to go down, the long position will lose money, and the short position will make money.

An important point here is that these contracts are binding. The entity, the party that is short, the party that sold this contract, has to deliver crude oil at the expiration date. If that party is not an oil-producing company, or if that party is not interested in delivering or cannot deliver the crude oil, they have to close their position, they have to cancel the contract. How? If they are short, they have to buy back; if they are long, they have to sell.