To many, crude oil futures are a concept: market data that serves as an input to what most of us are familiar with -- gasoline. Others believe that crude oil futures are only used by speculators to bet on the price of oil.
These beliefs could not be further from the truth. Oil producers, service companies, and transportation companies use crude oil futures to function. Futures trades help oil producers lock in prices for the future. Crude oil futures were invented to provide certainty -- the assurance necessary to invest in future production.
|WTI Crude (NYMEX)||$49.18|
|Brent Crude (ICE)||$54.21|
Why futures are useful
Futures contracts are a tool that speculators use to make money from price fluctuations. However, they also serve considerable social and financial purposes.
Imagine you're an airline like Southwest or American Airlines, using thousands of gallons of fuel every day. Should petroleum prices spike, airlines that don't contract to buy fuel at a future date -- buying a futures contract -- would either have to raise prices or lose money.
The solution to this problem is futures contracts. Futures contracts for the delivery of crude oil and other petroleum products provide a hedge for consumers of oil. After all, airlines are in the business of transporting people and goods.
There are risks, however, as with any financial transaction. One could promise to buy 1,000 barrels of WTI (West Texas Intermediate for delivery in Cushing, Oklahoma, the standard contract in the U.S.) three months from now, but might be overpaying. While that's unfortunate, in the long term, producers win as often as they lose.
As time goes on, most oil producers wind up overpaying as much as they do underpaying. This is acceptable to almost all market players. They gain from certainty, not from guessing at price fluctuations.
The same logic applies to actual crude oil producers. Crude oil production is an expensive business to be in. Last year, ExxonMobil spent a whopping $16.16 billion on capital expenditures. And this was actually down from 2015's $26.49 billion and 2014's $32.95 billion. Such a capital-intensive business requires some level of certainty. As a commodity, oil is inherently unpredictable. The historic prices of crude oil futures and spot prices bear this out. By hedging price risk, ExxonMobil and all other oil producers can gain the confidence needed to spend such large sums.
What affects crude oil futures prices?
When we speak of oil prices, we typically mean the current or "spot" price for a barrel of crude. A crude oil future is a contract for delivery of a barrel of crude on a specified date. The two "prices" for oil are typically similar but are rarely the same. The price for a barrel of crude oil today versus, say, three months from now is subject to three fundamental market forces:
|1. Current oil supplies||The sum of all oil produced in the world. The International Energy Agency (IEA) estimates this figure on a monthly basis.|
|2. Estimated future supplies||Oil is subject to the whims of supply and demand just like any other product. Both the spot and future price of oil can be affected by the market's estimate of how much is likely to be produced in the foreseeable future. This is also the lever OPEC is currently utilizing (via production cuts) in its attempt to increase oil prices.|
|3. Projected future demand||All stakeholders in the oil markets seek to estimate where demand for crude will be in the future. Rising demand from places like India and China implies rising prices, whereas falling demand from the U.S. thanks to fuel efficiency gains and the adoption of electric cars probably means falling oil prices.|
Today's financial markets are incredibly complex, and the oil futures market is no exception. Prices are based not only on current demand but on estimates for future supply and demand as well.
What it all means for investors
Crude oil futures contracts are an essential part of the global economy. Both producers and consumers of oil would find their businesses disrupted without the certainty that futures contracts provide.
While most people should not engage in the trading of crude oil futures, they are essential. This means one thing and one thing only: Crude oil futures trading should be left to the professionals.