Oil trading 101

For those of us who never studied finance or economics, terms such as hedging, futures and long position are very mysterious.  Let’s look at a basic oil trading strategy: selling the futures spread, to understand some of these terms.[i]

First of all, what is a futures contract?

If I sell a contract, to deliver 1000 barrels of oil in December 2015, I have  sold an oil futures contract.

For example, I promise to supply a customer, let’s call him Harry Potter, with 1000 barrels of oil in December. Harry pays this December price to secure his supply and I lock in a comfortable price. Why would Harry do that? If the December futures price is currently $50 Harry probably believes that, come December, the real oil price will have changed. If it turns out to really be $70 (multiplied by 1000 barrels!) then Harry has won. He paid his supplier – me – much less then he would have paid if he had waited until December.

$70 – the actual price of oil in December – is called the December “spot” price.

On the other hand, if it turns out the December spot price falls to $45 then the supplier made the better deal. I wait until December to buy 1000 barrels of oil at $45 each. I supply these barrels to grumpy Harry who already paid me $5 more per barrel and rather thought he had made a good deal back in March.

Oil future prices emerge because different players have different expectations about how oil prices will evolve.

Current market conditions

The oil futures market  is currently in deep contango. What does this mean? Contango means traders expect the price of a barrel of oil to be higher in the future than it is today. Deep contango means this price will be a lot higher. Yet, as we just saw above, when delivery day arrives the spot market might tell another story.

As a trader I need to make a prediction about what will happen over the next few months

For example:

  • Oil storage facilities are near capacity in Europe and essentially full in the US. Storage is becoming inaccessible.
  • Today’s spot prices are at a historic low. I might think they are likely to drop further, since producers cannot store oil to sell later and will be forced to dump their supplies somewhere.
  • Many producers are becoming unprofitable. Investment in new oil production projects is being put on hold because prices around $40-$50/barrel are not enough to cover production costs.
  • If there are few new projects to replace current production then oil supplies will eventually tighten and prices will increase. But not for at least a year or two. Identifying this lag is crucial.

This means the contango will deepen.

Based on the above predictions, I would expect the futures spread to widen. That is, the difference between the spot and future price of oil will get much bigger.[ii] Why?

To reiterate: spot prices will decrease as we have a situation of oversupply that is likely worsen when oil storage facilities run out. Then the oil futures price will increase, relative to spot, since the market is not expected to tighten for one or two years. This pattern should hold for some months.

My trading strategy, based on these expectations, is to sell the futures spread.[iii]

Selling the futures spread means I sell a futures contract for a near month  and buy a futures contract a far month. This will be profitable if I am right about the contango spread increasing.

For example:

It is March 2015.

SELL TIME SPREAD:

  • Sell April oil futures contract @ $48.13
  • Buy May oil futures contract @ $49.13
  • The spread is -$1 per contract.

It is now April 2015 and I need to offset my position.

BUY TIME SPREAD:

  • Buy April WTI spot contract @ $47.13
  • Sell May WTI futures contract @ $51.13
  • The spread is now -$4 per contract.

Intuitively -4.00 < -1.00

So I sold something at a higher price than I bought it back for. Profit!

My total profit is: (-1) – (-4) = $3 x 1000 contracts = $3000

A helpful guideline:

Which trading strategy to use?   Contango time spread (normal market) Backwardated time spread  (inverted market)
Expect the spread to widen Sell spread Buy spread
Expect the spread to narrow Buy spread Sell spread

Selling the spread:  short the near futures position and long the far futures position.

Buying the spread: long the near futures position and short the far futures position.


[i] Please be aware that this example is pure fiction and the author takes no responsibility for losses or gains made by anyone trading oil futures based on the above-described strategy.

[ii] It does not really matter what the price level is per se. So it’s not helpful to say “prices will go up.” Relative to what?

[iii] Short = sell, long = buy. These terms do not have anything to do with time-frames!

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