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2012-03-30 11:01:53
March 31 2011 | Filed Under Derivatives, Futures, Options
Energy prices can be extremely volatile, due to the fact that energy is
possibly the most tactical and political product in the world. The price of
energy affects not only industries, but nations, as well. In this article, we
will explore how the energy market influences almost everything that we do.
TUTORIAL: Futures Trading 101 What Are Energy Futures Contracts?
An energy futures contract is a legally binding agreement for delivery of
crude, unleaded gas, heating oil or natural gas in the future at an agreed upon
price. The contracts are standardized by the New York Mercantile Exchange
(NYMEX), as to quantity, quality, time and place of delivery. Only the price is
variable. (To read about the basics of futures, see Options Basics Tutorial and
Futures Fundamentals.)
Advantages of Futures Contracts
Because they trade at a centralized exchange, futures contracts offer more
financial leverage, flexibility and financial integrity than trading the
commodities themselves. (To keep reading about this subject, see Who sets the
price of commodities?, Commodities: The Portfolio Hedge and Commodity Prices
And Currency Movements.)
Futures contracts offer speculators a higher risk/return investment vehicle
because of the amount of leverage involved with commodities. Energy contracts
in particular are highly leveraged products. For example, one futures contract
for crude oil controls 1,000 barrels of crude. The dollar value of this
contract is 1,000-times the market price for one barrel of crude. If the market
is trading at $60/barrel, the value of the contract is $60,000 ($60 x 1,000
barrels = $60,000). Based on exchange margin rules, the margin required to
control one contract is only $4,050. So, for $4,050, one can control $60,000
worth of crude. This gives investors the ability to leverage $1 to control
roughly $15. (Find out more about leveraging in What is the difference between
leverage and margin?)
Contract Specifications
Energies are traded at a few different exchanges around the world, for example,
in London and now at the Intercontinental Exchange (ICE). Here, we will only
look at the contracts traded at the New York Mercantile Exchange (NYMEX).
Crude
Crude accounts for 40% of the world's energy supply, and is the most actively
traded commodity contract worldwide. Crude is the base material that makes gas,
diesel, jet fuels and thousands of other petrochemicals.
More specifically, the type of crude in question is the light sweet crude oil
variety, which, according to NYMEX, contains lower levels of sulfur. This type
of crude is traded in dollars and cents per barrel, and each future contract
involves 1,000 barrels. As in the example above, when crude is trading at $60/
barrel, the contract has a total value of $60,000. For example, if a trader is
long at $60/barrel, and the markets move to $55/barrel, that is a move of
$5,000 ($60 $55 = $5, $5 x 1,000 bl. = $5,000).
Movement
The minimum price movement, or tick size, is a penny. Although the market
frequently will trade in sizes greater than a penny, one penny is the smallest
amount it can move.
Crude has a daily limit of $10/barrel, which is expanded every five minutes as
needed. This means crude will never have an upper or lower lock limit.
Remember, a $10 difference in a barrel of oil is a move of $10,000 per
contract.
Delivery
The requirements of the exchange specify delivery to numerous areas on the
coast and inland. These areas are subject to change by the exchange. For
example, currently for the NYMEX, the delivery point is in Cushing, Oklahoma.
Because energy is in such demand, is it deliverable all 12 months of the year.
To maintain an orderly market, the exchanges will set position limits. A
position limit is the maximum number of contracts a single participant can
hold. There are different position limits for hedgers and speculators.
Heating Oil
According to NYMEX, heating oil accounts for 25% of the yield of a barrel of
crude, and is the second-largest yield after gas. Heating oil futures are used
by a wide variety of businesses to hedge their exposure to energy cost.
Heating oil is traded in dollars and cents per gallon. One contract of heating
oil controls 42,000 gallons, or one rail car. When the price of heating oil is
trading at $1.5000/gallon, the cash value of that contract will be $63,000
($1.5000 x 42,000 = $63,000).
Movement
The tick size is $0.0001 per gallon, which equates to $4.20 for each contract.
For example, if one was to go long at $1.5500 and the markets moved to $1.5535,
one would have a profit of $147 ($1.5535 - $1.5500 = $0.0035, $0.0035 x 42,000
= $147). Conversely, a move to $1.5465 would equal a loss of $147. Heating
oil's daily limit is 25 cents, which is $10,500 per contract.
Delivery
Heating oil contracts are deliverable for 18 consecutive months, and the
delivery point is at New York Harbor.
Heating oil, like crude, also has position limits set by the exchanges, which
are no more than 7,000 contracts in total, and no more than 1,000 contracts
during the last three days of the current month.
Unleaded Gas (RBOB)
Gasoline is the single largest refined product in the U.S. and accounts for
half of the national consumption of oil. Besides the large demand for gas,
there are numerous of other factors, like government laws, which can affect the
price. Reformulated gasoline blendstock for oxygen blending (RBOB) is a newer
blend of gas which allows for 10% fuel ethanol.
Gas is traded in the same 42,000-gallon (1,000 barrels) contract size as
heating oil. It is also traded in dollar and cents, so if the market is trading
at $2/gallon, the contract will have a value of $84,000 ($2 x 42,000 =
$84,000). Like the rest of the energies, this is a high dollar value contract
and is quite leveraged. The daily limits here equate to a move of $10,500 per
contract or 25 cents/gallon.
Movement
The minimum tick size is $0.0001, or a total of $4.20 for each contract. So any
10-cent move in unleaded gas will equate to either a gain or a loss of $4,200.
Delivery
Gas is deliverable all year-round; it has position limits and the delivery
point usually takes place at the future seller's facility.
Natural Gas
According to the U.S. Energy Information Administration, about 25% of the total
energy consumption in the United States is natural gas. Within the 25%, about
half is used by industry, while the other half by commercial and residential
users. Natural gas is one of the bigger futures contracts that are traded
worldwide. One contract equals 10,000 MM Btus (million British thermal units).
If the current market price is $6 per MM Btus, the contract has a value of
$60,000 ($6 x 10,000 MM Btus = $60,000).
Movement
The minimum tick is $0.001, or $10 per tick per contract. For example, let's
say you buy a contract of natural gas when the market is at $6, and then sell
it at $7. In this transaction, you would have made $10,000 on the $1 move in
natural gas.
Delivery
Like other energies, natural gas is deliverable all year round and has position
limits. The delivery point for natural gas traded on the NYMEX is at the Sabine
Pipe Line Company's Henry Hub, which is located in Louisiana.
Hedgers and Speculators
The primary function of any futures market is to provide a centralized
marketplace for those who have an interest in buying/selling physical
commodities at some time in the future. The energy futures market helps hedgers
reduce the risk associated with adverse price movements. There are a number of
hedgers in the energy markets because almost industrial sectors uses energy in
some form. The energy complex is quite volatile and takes quite a bit of
capital to get involved, although there are new e-mini contracts available,
which are growing in volume month by month.
Conclusion
It is important to note that trading in this market involves substantial risks
and is not suitable for everyone - only risk capital should be used. Any
investor could potentially lose more than originally invested. To read about
more commodities and their specific markets, see Grow Your Finances In The
Grain Markets, The Sweet Life Of Soft Markets, Water: The Ultimate Commodity,
Trading Gold And Silver Futures Contracts and What Is Wrong With Gold?
by Hank King