Oil Futures: Reducing Risk in a Volatile Market

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Crude oil prices are in contango. Contango means the expected future price of a barrel of oil is higher than the current spot price. That’s a good thing, right? When Harold Hamm says “Avoid selling that production in this poor market and wait for service costs to fall before completing those wells,” he’s basing his recommendation partly on the idea that oil prices will soon rise enough to set the stage for a return to more profitable US oil operations.

What are futures contracts?

Futures contracts are a kind of financial derivative – a contract that derives its value from the performance of an underlying entity. Since that explanation is obtuse, I’ll try to explain by using a more concrete example, and then move into oil futures.

If you buy a house with a mortgage, the bank (or whoever you established the loan with) can sell that mortgage to another bank or entity, and they in turn can sell it to another and so on and so on. Unless you default on the loan, the bearers of that mortgage don’t actually own your home, but they do own the right to the agreed-upon income from the loan under the terms established. So a mortgage becomes a product one can buy and sell based on the underlying value of the projected income – a financial derivative.

Commodity futures are derived products as well. If you’ve seen Trading Places with Eddie Murphy and Dan Aykroyd, the frozen orange juice concentrate market that they “rig” with insider information is a commodity futures market. No-one is actually buying physical oranges, not Billy Ray or Louis, and certainly neither of the Duke brothers. They are, however, buying and selling the rights to the income from those oranges.

Energy became a popular tradeable commodity in response to the 1973 Oil Crisis. When the price of oil quadrupled, traders found a useful futures hedge in the heating oil commodity market. Since then a number of exchanges have started trading energy futures and other derivatives (like swaps and options). The current market uncertainty is focused on crude oil, so we will focus on the major crude oil futures markets, although there are also futures markets for gas, electricity, refined products and even carbon emissions.

West Texas Intermediate – Chicago Mercantile Exchange

West Texas Intermediate (WTI) was launched as an oil commodity futures index for the Chicago Mercantile Exchange (CME) in 1986, based on spot prices for intermediate grade crude (~39.6 API) at Cushing, Oklahoma. Cushing is a major hub for the transportation of crude oil, with dozens of major pipelines and approximately 85 million barrels of crude oil storage capacity. The WTI has $80.7 billion of outstanding futures contracts as of 3/10/2015.
Oil Futures: Reducing Risk in a Volatile Market

Brent Crude – Intercontinental Exchange

The International Petroleum Exchange (IPE) was founded in 1980 and launched Brent Crude futures in 1988. Originally named for oil from the Brent Oilfield in the North Sea, Brent Crude is slightly heavier than WTI at ~38.06 API. The IPE was acquired by the Intercontinental Exchange (ICE) in 2001, who changed the trading method from “open outcry” (trading in an open “pit” like in Trading Places) based in London to an electronic exchange. Brent Crude has $106 billion of outstanding futures contracts as of 3/10/2015.

NEW: NASDAQ

Nasdaq recently announced the impending launch of Nasdaq futures as a new player in the energy futures market. They are aiming a deep discount vs. CME and ICE trading fees and are optimistic that they can grab a significant share of the energy futures market within the next couple of years.

Who buys futures, who sells futures, who makes money?

Hedgers

Hedgers are primarily interested in limiting uncertainty about the price at which they can buy or sell their future production, in this case crude oil.

  • Producers – want to maximize the amount of money per barrel and protect themselves against any decrease in spot prices
  • Refiners – want to reduce the amount of money per barrel and protect themselves against any increase in spot prices

Speculators

Oil Futures: Reducing Risk in a Volatile MarketSpeculators are primarily interested in movement within the price of their chosen commodity, and generally have no interest in the commodity itself. Volatility within the market allows them to attempt to buy low and sell high (or even bet against that flow) and keep the difference for themselves.

  • Banks – Banks serve a couple of basic functions in modern society, chiefly holding on to cash for people or businesses (a liability since they have to be able to give the cash value back at any given time) and making loans to people or businesses (an asset since it represents predictable income). Banks will typically put the capital they are safeguarding to work by making investments.
  • Funds – Investment funds like hedge funds and mutual funds pool large amounts of money from investors, and manage the investment of the pool. Mutual funds are closely regulated, available to the general public, and generally perform on par with the stock market. Hedge funds are private and therefore have fewer regulations, notably their ability to use borrowed money to enhance their assets.
  • Individuals – Andrew Hall is an example of an investor who has taken a beating during the current oil price decline, but has more than compensated that loss by concurrently speculating on the dollar.

Exchanges

The CME and the ICE (and soon NASDAQ) make a fee for every transaction on their markets.

What is affecting oil futures currently?

Strong Supply

With the consistent improvement in unconventional E&P, oil production in the US has been ramping up steeply since 2011. The higher prices available during that time helped fund a lot of improvements in the technology of “tight” oil production, so much so that even after a steep reduction in the amount of active drilling, and a large amount of drilled wells being held for completion, monthly US production output is still growing.

Oil Futures: Reducing Risk in a Volatile Market
Image Source: https://www.smarteranalyst.com/2015/02/13/oil-price-heading-2015/
Worldwide we are seeing improved production output as well, with some previously politically unstable oilfields coming and staying online, such as Iraq and Angola.

Geopolitics

In an effort to protect their share of the global crude oil market, Saudi Arabia has deliberately chosen to not reduce their flow of oil into the world market. Historically, other OPEC member countries haven’t necessarily followed production quotas as established, and are all hungry to keep income flowing, so they are all unlikely to scale back production. This week, the mere idea that Iran may someday bring nuclear energy online (thereby indicating a future decline in the amount of oil they consume) has created negative movement in the oil price market.

Weak demand growth

This is perhaps the hardest factor to actually quantify, and will be the subject of a future post or two. For now, the previous high-cost of energy resulted in a number of efficiency improvements and increased frugalness. For example, North Americans have been driving fewer per-driver miles in more efficient cars. Globally, demand growth in China and India has slowed down. Basically, because energy has been expensive people and companies have all been working on ways to get more output from fewer resources, and now that more resources are available they don’t need those resources, even at a cheaper price point.

Storage woes

The Cushing hub is starting to fill up with oversupplied crude. Since the US cannot export crude, there is no option of unloading WTI onto the world market. This is driving a significant wedge between the price of Brent and the price of WTI. An additional effect of the over-abundance is that storage costs have been going up, from dimes per barrel to dollars per barrel. (According to the WSJ, speculators are still in position to make money from selling stored barrels forward).

Strong dollar

Economically, The United States is doing great, and the value of the dollar vs. international currency is very strong. Although in general this is good for the country, it does create a further imbalance in energy prices, since it effectively makes the cost of anything from America more expensive on the global market. Also, because oil is usually priced in dollars, the strong dollar means the drop in price is less of a benefit in euro, yen and other currencies because it takes more of their domestic currency to buy a barrel of oil priced in dollars.

Conclusion

Oil Futures: Reducing Risk in a Volatile MarketWith the return of volatility and uncertainty in crude oil price, the oil futures markets has brought some stability to oil producers. Though some speculators in the oil futures market may have taken a bath vs. hedgers with the recent 50% decline in price, the volatility in the market continues to entice further speculation which will continue to impact the oil producers bottom line during the predicted lean months ahead.

Your Turn

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Eric Roach

Eric Roach is the editor of Drillinginfo's blog, which was selected as the Top Oil & Gas Industry Blog based on visibility, engagement and relevance. He also prepares a weekly newsletter of top industry news for blog subscribers, and would be grateful if you would subscribe and tell your friends. (There's a box on the upper right of the page where you can subscribe).