The industry that drives global commerce and ensures our highest standards of living is underpinned by the complex and fascinating world of commodity trading.
Without commodity trading, our lives would be vastly different. The exchange of physical commodities like crude oil, natural gas, metals and power guarantee that we can do everything from turning the lights on, to receiving packages in the mail, to charging our cell phones.
The intricacies of commodity trading are hard to grasp without the right language, and several of the terms and definitions used by traders are unique from those used by the buyers and sellers of other assets like stocks, bonds, equities or even cryptocurrencies.
Since forward curve management stands at the foundation of Enverus’ key risk management solutions for the energy industry, I figured it might be helpful to take a step back and define what a forward curve is, and why it’s integral to any trading operations’ bottom line. We all have to start somewhere. This post is dedicated to the newbies.
What is a forward curve, and why is it important for risk management?
Simply put, a forward curve is a snapshot representation of what a commodity is currently worth today based on a possible buy or sell in the future. Using a forward curve, I can tell you what the price of WTI crude futures is currently for barrels that would change hands in 2024. Tomorrow, the forward curve will likely determine a different price.
A forward curve is built using the current day’s price values to exchange a commodity at some point in the future, and the commodity’s value will change as time progresses. This is why forward curves are not a price forecast like the formal weekly, monthly, or annual predictions that our analysts produced based on more in-depth fundamentals data. Instead, it’s an indicator based solely on the bids and offers in the marketplace for that day.
Let’s pause and view an example of how prices can be sewn together to create a forward curve. It’s easiest to explain using an instrument called a futures contract, which is exactly what it sounds like: a contract that traders exchange for a determined volume and commodity at a future time period.
While these contracts are bought and sold virtually on exchanges like ICE or Nymex, they represent the buying or selling of a real, tangible product. If you purchase a contract and forget about it, you will be responsible for taking delivery of the commodity you ordered.
At any given moment in a trade day, there are absolute values for futures contracts far into the future – you can see here that even for contracts delivering crude in March 2022, there are thousands of trades taking place. Each of these transactions influences the movement of the price of futures for the various contract months.
This list of monthly contract prices that we have from the above data, between February 2021 and March 2022, is the foundation of a forward curve. But it makes a lot more sense plotted out in a chart, like this:
A trader can look at a chart like the one above and quickly tell you if the market is oversupplied or undersupplied – and will define the market structure as either backwardated or contango.
Do you now find yourself asking, “backward-what-now?”
Trust me when I say that I did not just make up those words. Stay tuned for part 2 – where we will dive into the difference between backwardation and contango and share the ways that forward curves can be utilized as a risk management tool for merchants executing complex commodity trades.
The great news for now: you don’t have to be a quant to build complex forward curves. Enverus CurveBuilder gives all people in a commodity trade floor – from storied traders to brand new market analysts – the power to build complex forward curves.