A futures contract is an agreement that calls for a seller to deliver to a buyer a specified quantity and quality of an identified commodity, at a fixed time in the future, at a price agreed to when the contract is made. An option on a commodity futures contract gives the buyer of the option the right to convert the option into a futures contract. Energy futures and options contracts are used by energy producers, petroleum refiners, traders, industrial and commercial consumers, and institutional investors across the world to manage their inherent price risk, to speculate on price changes in energy, or to balance their portfolio risk exposure.
With very limited exceptions, futures and options must be executed on the floor of a commodity exchange through persons and firms registered with regulatory authorities. The contracts are traded either by open outcry, where traders physically transact deals face to face in specified trading areas called pits or rings, or electronically via computerized networks. The futures market provides a standardized trading environment such that all users know exactly what they are trading and where their obligations and risks lie. By entering into a standard futures and/or options contract, a certain amount of price assurance can be introduced into a world of uncertainty and price volatility.
Most futures contracts assume that actual delivery of the commodity can take place to fulfill the contract. However, some futures contracts require cash settlement instead of delivery. Futures contracts can be terminated by an offsetting transaction (i.e., an equal and opposite transaction to the one that opened the position) executed at any time prior to the contract's expiration. The vast majority of futures contracts are terminated by offset or a final cash payment rather than by physical delivery.
Futures contracts for agricultural commodities have been traded in the United States since the nineteenth century and have been under federal regulation since the 1920s. Starting in the late 1970s, futures trading has expanded rapidly into many new markets, beyond the domain of traditional physical and agricultural commodities such as metals and grains. Futures and options are now offered on many energy commodities such as crude oil, gasoline, heating oil, natural gas, and electricity, as well as on a vast array of other commodities and financial instruments, including foreign currencies, government securities, and stock indices.
TERMS AND CONDITIONS
A typical futures contract might call for the delivery of 1,000 barrels (42,000 U.S. gallons) of unleaded gasoline meeting defined specifications at petroleum product terminals in New York Harbor during the next twelve months at an agreed price in dollars and cents per gallon. All terms and conditions other than the price are standardized. Gasoline is sold through hundreds of wholesale distributors and thousands of retail outlets, and is the largest single volume refined product sold in the United States. It accounts for almost half of national oil consumption. A market that diverse is often subject to intense competition, which in turn breeds price volatility and the need for reliable risk management instruments for energy producers and users.
There are two types of options — call options and put options. A call option on a futures contract gives the buyer the right, but not the obligation, to purchase the underlying contract at a specified price (the strike or exercise price) during the life of the option. A put option gives the buyer the right to sell the underlying contract at the strike or exercise price before the option expires. The cost of obtaining this right to buy or sell is known as the option's "premium." This is the price that is bid and offered in the exchange pit or via the exchange's computerized trading system. As with futures, exchange-traded option positions can be closed out by offset.
HOW FUTURES AND OPTIONS DIFFER
The major difference between futures and options arises from the different obligations of buyer and seller. A futures contract obligates both buyer and seller to perform the contract, either by an offsetting transaction or by delivery. Both parties to a futures contract derive a profit or loss equal to the difference between the price when the contract was initiated and when it was terminated. In contrast, an option buyer is not obliged to fulfill the option contract. Buying an options contract is similar to buying insurance. The buyer is typically paying a premium to remove risk, while the seller earns the premium and takes on risk. The option buyer's loss is limited to the premium paid, but in order for the buyer to make a profit, the price must increase above (call option) or decrease below (put option) the option's strike price by more than the amount of the premium paid. In turn, the option seller (writer or grantor), in exchange for the premium received, must fulfill the option contract if the buyer so chooses. Thus, the option's exercise takes place if the option has value (is "in the money") before it expires.
FEATURES NEEDED FOR A WELL-FUNCTIONING MARKET
Whatever the item, such as crude oil, underlying the futures or options contract, every market needs certain ingredients to flourish. These include
- Risk-shifting potential—the contract must provide the ability for those with price risk in the underlying item to shift that risk to a market participant willing to accept it. In the energy world, commercial producers, traders, refiners, distributors and consumers need to be able to plan ahead, and frequently enter into commitments to buy or sell energy commodities many months in advance.
- Price volatility—the price of the underlying item must change enough to warrant the need for shifting price risk. Energy prices are subject to significant variance due to factors affecting supply and demand such as level of economic activity, weather, environmental regulations, political turmoil, and war. Market psychology also plays its part.
- Cash market competition—the underlying cash (or physicals) market for the item must be broad enough to allow for healthy competition, which creates a need to manage price risk and decreases the likelihood of market corners, squeezes, or manipulation. The physical market in energy commodities is the largest such market in the world.
- Trading liquidity—active trading is needed so that sizable orders can be executed rapidly and inexpensively. Popular markets such as crude oil, heating oil, and unleaded gasoline have thousands of contracts traded daily.
- Standardized underlying entity—the commodity or other item underlying the futures contract must be standardized and/or capable of being graded so that it is clear what is being bought and sold. Energy commodities are fungible interchangeable goods sold in accordance with strict specifications and grades.
Energy is considered to be a well-functioning market because it satisfies these criteria. The existence of such a market has a significant modifying effect on short-term price volatility, and will temper the impact of any future disruptions such as those that occurred in the pre-futures market 1970s. However, even a well-functioning futures market cannot be expected to eliminate the economic risks of a massive physical supply interruption.
Most of the participants in the energy futures and option markets are commercial or institutional energy producers, such as petroleum producers, refiners, and electric utilities; traders; or users, such as industrial and transportation companies. The energy producers and traders, most of whom are called "hedgers," want the value of their products to increase and also want to limit, if possible, any loss in value. Energy users, who are also hedgers, want to protect themselves from cost increases arising from increases in energy prices. Hedgers may use the commodity markets to take a position that will reduce their risk of financial loss due to a change in price. Other participants are "speculators" who hope to profit from changes in the price of the futures or option contract. It is important to note that hedgers typically do not try to make a killing in the market. They use futures to help stabilize their revenues or their costs. Speculators, on the other hand, try to profit by taking a position in the futures market and hoping the market moves in their favor. Hedgers hold offsetting positions in the cash market for the physical commodity but speculators do not.
THE MECHANICS OF TRADING
The mechanics of futures and options trading are straightforward. Typically, customers who wish to trade futures and options contracts do so through a broker. Both, buyers and sellers, deposit funds—traditionally called margin, but more correctly characterized as a performance bond or good-faith deposit—with a brokerage firm. This amount is typically a small percentage—less than 10 percent—of the total value of the item underlying the contract.
The New York Mercantile Exchange (NYMEX ) is the largest physical commodity futures exchange in the world. The exchange pioneered the concept of risk management for the energy industry with the launch of heating oil futures in 1978, followed by options and/or futures for sweet and sour crude oil, unleaded gasoline, heating oil, propane, natural gas, and electricity. The NYMEX is owned by its members and is governed by an elected board of directors. Members must be approved by the board and must meet strict business integrity and financial solvency standards.
The federal government has long recognized the unique economic benefit futures trading provides for price discovery and offsetting price risk. In 1974, Congress created the Commodity Futures Trading Commission (CFTC), replacing the previous Commodity Exchange Authority, which had limited jurisdiction over agricultural and livestock commodities. The CFTC was given extensive authority to regulate commodity futures and related trading in the United States. A primary function of the CFTC is to ensure the economic utility of futures markets as hedging and price discovery vehicles.
The London-based International Petroleum Exchange (IPE) is the second largest energy futures exchange in the world, listing futures contracts that represent the pricing benchmarks for two-thirds of the world's crude oil and the majority of middle distillate traded in Europe. IPE natural gas futures may also develop into an international benchmark as the European market develops larger sales volume.
Besides NYMEX and IPE, there are a number of other exchanges offering trading opportunities in energy futures. These include the Singapore International Monetary Exchange (North Sea Brent crude), The Chicago Board of Trade (electricity), Kansas City Board of Trade (western U.S. natural gas), and the Minneapolis Grain Exchange (Twin Cities' electricity). Domestic energy futures trading opportunities have arisen due to deregulation of the electricity and natural gas industries introducing many new competitors prepared to compete on the basis of price.
There has been discussion of the possibility of a futures market in emission credits arising from domestic regulations or international treaties to reduce energy use-related greenhouse gas emissions. These so-called pollution credits would be generated when Country A (or Corporation A) reduces its emissions below a specific goal, thereby earning credits for the extra reductions. At the same time, Country/Corporation B decides that emission controls are too expensive, so it purchases A's emission reduction credits. A declining cap on allowable emissions would reduce the available number of credits over time. The controversial theory is that market forces would thereby reduce emissions. Although there is some U.S. experience with the private sale and barter of such emission credits (a cash or "physicals" market), it remains to be seen if a true exchange-traded futures market in emission credits will arise.
ENERGY AND FUTURES PRICES
In addition to providing some control of price risk, futures and options markets are also very useful mechanisms for price discovery and for gauging market sentiment. There is a world-wide need for accurate, real-time information about the prices established through futures and options trading, that is, a need for price transparency. Exchange prices are simultaneously transmitted around the world via a network of information vendors' terminal services directly to clients, thereby allowing users to follow the market in real time wherever they may be. Energy futures prices are also widely reported in the financial press. These markets thus enable an open, equitable and competitive environment.
Frank R. Power
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"Futures." Macmillan Encyclopedia of Energy. . Encyclopedia.com. (November 19, 2018). https://www.encyclopedia.com/environment/encyclopedias-almanacs-transcripts-and-maps/futures
"Futures." Macmillan Encyclopedia of Energy. . Retrieved November 19, 2018 from Encyclopedia.com: https://www.encyclopedia.com/environment/encyclopedias-almanacs-transcripts-and-maps/futures
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