Personal Finance

What Are Crude Oil Futures and How Do They Work?

Oil Pump Gettyimages
Oil Pump Gettyimages

Image source: Getty Images.

Energy prices are important for everyone, and the plunge in crude oil prices in 2015 showed just how important key commodities can be for consumers and investors alike. For investors, crude oil futures offer an opportunity to profit from fluctuations in energy prices, but they work a lot differently from just buying shares of an oil and gas producer. Below, you'll learn the basics of crude oil futures and the impact that they can have on your portfolio.

What crude oil futures are

Crude oil futures are futures contracts in which buyers and sellers of oil coordinate and agree to deliver specific amounts of physical crude oil on a given date in the future. The benchmark futures contract for crude oil in the U.S. involves West Texas Intermediate, a particular grade of oil that has fairly low density and sulfur content that makes relatively easy to refine. It has historically traded on the New York Mercantile Exchange, and therefore many traders refer to the contracts as NYMEX WTI crude oil futures. Trading is also common globally for what are called Brent crude oil futures, which involve a different grade of oil found in the North Sea off the European continent.

The specifications for crude oil futures contracts are set in a way that allow market participants to trade them uniformly. Each contract covers 1,000 barrels, and dates for delivery are available up to nine years into the future. At some point during the delivery month, the seller must deliver the oil to the buyer at a pipeline or storage facility in the energy hub of Cushing, Oklahoma, with official transfer of title accompanying the actual physical movement of oil.

How to use crude oil futures

As you can see, the primary purpose of crude oil futures is to connect producers of oil with consumers of oil. Oil producers can sell futures contracts that match up to their expected future production, and by doing so, they can effectively lock in current prices. Although futures contract prices change every day, a seller receives financial credit when futures prices go down, offsetting the drop in oil's market price. For instance, if a contract falls from $50 per barrel to $49, then the seller will get a $1,000 credit, corresponding to the $1 decline multiplied by the 1,000 barrels covered by the contract. Conversely, if the contract rises from $50 to $51, the seller takes a $1,000 loss, offsetting the eventual gain the seller will get in future by having a higher price.

Buyers who need crude oil as a raw material, on the other hand, such as refinery companies, can ensure they have adequate future supplies and lock in favorable pricing. For buyers, the finances of futures work in the opposite direction. Rising prices give them a financial credit, while falling prices cost them. The net effect, though, is to set the price actually paid for the oil at the level at which the buyer entered into the futures contract in the first place.

Oil Refinery Gettyimages

Image source: Getty Images.

Crude oil futures and speculation

Investors generally aren't interested in taking possession of thousands of barrels of crude oil. Many traders participate in futures markets without ever dealing with actual physical delivery. As long as you close out your futures position before the expiration date of the contract, then you can experience the same financial gains and losses as other participants from the daily movements of futures prices.

In order to trade futures, however, you have to set up a margin account with a broker that handles futures trading. In order to cover potential losses, you also have to maintain a certain amount of equity in the account. For NYMEX crude oil futures, the current margin maintenance requirements range from $2,900 to $3,400 depending on the date of the contract. If losses push the available capital in your margin account below that level, then you'll have to deposit more money in order to keep your futures position.

Even if you never trade in futures yourself, keep in mind that any energy companies in which you invest likely use futures for their own account. Therefore, understanding how crude oil futures work can give you a lot of insight into how companies' share prices should react to changing oil prices. For instance, a producer that has already sold futures on most of its future production shouldn't react much when oil prices change. Those that don't participate in the futures markets, however, are largely unhedged and can see a lot of volatility when oil prices move sharply.

Crude oil futures are an integral part of how the energy industry operates. The futures markets can be a risky place for individual investors, but energy companies that use futures well can often boost their profits or avoid losses that their peers end up suffering.

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