Pricing ANS: Part 2 – Futures Markets

In part 1 of this series, I laid out who the buyers, sellers, and shippers of Alaska North Slope (ANS) oil are. Those players make up the physical market, in which market fundamentals – the laws of supply and demand – determine prices.

But, there is another market that buys and sell crude oil. It’s called the futures market. Understanding the futures market is important to understanding oil pricing in the real world. It’s where the constantly changing market price is determined. Let’s explore the different ways oil is bought and sold.

OTC vs. Exchange Contracts

To get started, imagine that you wanted to sell your house. You have two options. One option is to put a sign in the yard that says “For sale by owner.” You would negotiate directly with potential buyers. Another options is to list your home with real estate broker. That broker would put your sell request into the system for other brokers to see. If they find an interested buyer, you enter a sales contract.

Now, imagine that you have 1,000 barrels of oil to sell. You basically have the same choices. You can use an in-house marketing team to locate a buyer, or you could call a commodity broker. A broker would work with a commodity exchange to list your “open interest.” If they find an interested buyer, you get matched and enter a sales contract.

The first case, with direct negotiations between a buyer and a seller, is called an over-the-counter (OTC) transaction. In the latter, using a broker to match buyers and sellers, it’s called a commodity exchange transaction. For our purposes, there are only two exchanges that matter: the New York Mercantile Exchange (NYMEX – a part of CME group) and the Intercontinental Exchange (ICE).

Just for the sake of terminology, there are two crude blends that come up most often. West Texas Intermediate (WTI) is oil produced in the United States; Brent is oil the comes out of the North Sea (Europe).

When you see an exchange generated contract, it will usually reference the exchange that created it and the blend being exchanged. In most cases, you should see either NYMEX WTI or ICE Brent.

So, you basically have US crude traded on the US exchange and international oil traded on the international exchange. There are also NYMEX Brent contracts, but there are fewer of those.

Spot Market

When you need milk for breakfast, you go to the grocery store. When a refinery needs oil for immediate use, they go to the spot market. Spot market transactions lead to immediate delivery. Well, as close to immediate as you can get. It might take a week or two for shipping. But, money changes hands and the logistics get sorted out as soon as the deal is done.

Spot market transactions are as close as you can get to the “real” price that oil is selling for today. But, there are not enough of these transactions in a publicly traded forum to really track them in real time. The EIA publishes spot prices on a week lag, and a couple of companies publish estimates at the end of each day. Additionally, spot sales often occur under unusual circumstances – like a buyer unable to take delivery.

Forward Contracts

More often, a refinery wants to have a better grasp on its inventory than buying off the spot market. Just like you don’t want to run out of milk before going to the store, the refinery wants to plan ahead. It has two options.

First, it could buy more than it needs, store the excess, and then use its inventory to smooth out delivery lags. Second, it could schedule advanced delivery of shipments. These advanced delivery contracts are called forward contracts. Then often stay in effect for several years. For instance, a refinery might enter a forward contract for one cargo per month for three years.

A forward contract is an over-the-counter agreement between a buyer and a seller. It sets the terms, price, and future delivery date for crude. These forward contracts can be for a single delivery or can cover several deliveries over months or years.

The price could be a fixed number (like $40 per barrel), but that would require agreeing on a price in advance. More often, the parties let the market determine the ultimate price. The contract simply uses a price marker – with an adjustment for quality, shipping costs, and composition differences.

For example, a refinery purchasing oil produced in the North Sea might set the delivery price at the calendar month average (CMA) of Dated Brent minus $3 per barrel. National oil companies might have an “official selling price” (OSP) rather than a price peg in their contracts.

The big distinction here is that forward contracts are not usually resold on a secondary market. They are made between a producer and a refinery. Those parties enter the contract expecting to deliver on its terms.

Futures Contracts

Unlike a forward contract, a futures contract is a structured instrument created by a commodity exchange. It’s also a contract between a buyer and a seller for a specified future period. But, the names of the buyer and seller can change multiple times before the delivery date approaches.

Every futures contract of the same type has identical specifications. The exchange provides certain guarantees to participants. This makes the contracts interchangeable and a good vehicle for investors.

For NYMEX WTI futures, the contract settles with physical delivery during the contract month. For instance, the seller on a December 2020 contract would deliver 1,000 barrels of oil to Cushing, Oklahoma between the 1st and 31st of December 2020. The buyer would by responsible for that oil after delivery, including storage costs. The seller doesn’t have to be the one that extracted the oil from the ground, but they do have to deliver 1,000 barrels of crude with less than 0.42% sulfur and at a gravity of at least 37 degrees API. Differences in quality come with an adjustment to the delivery price.

The Intercontinental Exchange (ICE) operates a little differently than the NYMEX. There is no physical delivery attached to an ICE futures contract. All oil contracts are also for 1,000 barrels, but the contract is always settled in cash. Deliveries occur on forward contracts while participants in the ICE futures use the cash settlements to offset changes in the commodity’s price.

Trading Paper

Most of the people buying and selling futures contracts aren’t really trying to participate in the physical market. Less than 5% of oil futures contracts actually result in the physical exchange of barrels of oil. That’s why people call these “paper barrels.” The underlying asset is imaginary and exists only on paper for the purpose of trade. In the NYMEX, if a contract reaches the expiration date without being closed, it’s said to become “wet.” Those paper barrels become real ones.

To understand what’s going on, we need to understand the players. Those that actually want to buy and sell wet barrels on the exchange and those that only want to participate in the paper market.

Hedgers

Refinery and oil extraction companies make up the physical market for oil. They often buy and sell the oil to each other on the spot market or through forward contracts. But, there are many reasons to participate in a commodity exchange. For one, they might use the exchange for actual sales and purchases. That could make more sense than direct negotiations.

Or, they might just want to remove some of the uncertainty about what prices will do in the future. The supply and demand for oil changes rapidly from month to month. There’s no way to know if weather or war will remove supply from the market, making the price go up. Or, if a pandemic will knock half the demand off the market, causing prices to crash.

A refinery might be worried about a price spike. A producer might be concerned about a price collapse. So, these participants might enter a futures contract to lock in a future price as a hedge against uncertainty.

Buyer Hedging Example

Imagine the price of oil today is $30 a barrel. Let’s say a refinery wants to protect itself from the price going up. They have two options. First, they could buy the oil at the current price and store it until they need it. But, that comes with some carrying cost. Second, they could call up the commodity exchange and inform them of their interest to buy oil for delivery in three months. To determine their offer price, they need to compare their options.

They could just wait until the delivery month and pay the spot price. Or, they could purchase oil today and pay the storage cost until they need the oil. The most they should be willing to pay is the lesser of the expected future spot price, or the current spot price plus storage cost. Their economists get to work and determine that they should bid no more than $32 a barrel to remove the risk that prices jump higher than that.

When the delivery month rolls around, say the spot price is $35 a barrel. the refiner already paid $32 a barrel for the contract. So, they end up saving $3 per barrel versus buying spot. Note that it doesn’t matter if they pay the $32 per barrel directly for the physical delivery of the oil, or if they cash settle the contract for $35 a barrel and use the money from the contract to buy spot. The result is identical. In the former case, they pay $32. In the latter, they bought the contract for $32, sold it for $35, and used the $35 to buy the oil. In either case, only $32 per barrel came out of their pocket.

Seller Hedging Example

Now, put yourself in the seller’s position. As an oil producer, you also have price risk to deal with. If the price of oil in three months falls to $20 a barrel (again, assume $30 today), your revenues will be far less than expected. Because the oil hasn’t been produced yet, you don’t have the luxury of locking in today’s spot price. But, once the oil is out of the ground, it can choose to put it in storage rather than accept the going rate. So long as you believe the price will go up in the future, by more than the storage cost, you could elect to do that.

Of course, if you are afraid the price won’t go up, you could get stuck losing even more money. So, you might call the commodity exchange an express interest in selling a futures contract. Your economist would get to work, comparing the cost of storage and the probability of the price going up or down, and determine they would be better of with any secured price of $32 or more.

Again, when the delivery month rolls around, the spot price is $35. In this case, you ended up selling your oil for $32 rather than the $35 you would have got on the spot market. And, again, it doesn’t matter if it’s physical delivery at that price, or a cash settlement followed by a spot sale. The end result is the same. You end up with $32 per barrel in your pocket.

Speculators

In the previous discussion, notice two things. First, the physical market always determines the ultimate price, but hedgers can shed risk through futures contracts. Second, the futures contract is always zero-sum. There is a winner and a loser in terms of final positions. The gains of one party offset the losses of the other. Both parties removed risk by participating, but only one ends up with a financial gain to boot. The other simply paid a price for protection from something that didn’t end up happening.

Keep those same factors in mind as we talk about the other people in the market – Speculators. These people are investors that have beliefs about the future price of oil. But, they don’t actually want the barrels or have any to sell. The are kind of like retail stores. They buy the products with the intent to resell them – not to use them.

A speculator can purchase and existing contract, or they can express open interest to the commodity exchange. And, they can be on either side of the contract. For example, if a front-month contract is priced at $32, an investor can look at a weather forecast and say “I think that hurricane is going to take supply offline in the Gulf of Mexico.”

If she’s right, the price of oil would go up in the physical market when it happens. So, she might be willing to pay $33 a barrel today, expecting to resell the contract for more than that when the price goes up. If she ends up being right, the price will go up and she will cash in. If she’s wrong, the price won’t go up, and she ends up selling her contract for less than she paid for it. Her actions price the risk of a future event into the contract before it happens.

When thousands of investors are constantly betting on what will happen next, the market price of these contracts reflects the sentiment of the traders. Therefore, the price of futures contracts has a degree to psychology included in them, with a grounding in the fundamentals. And, the closer the contract is to delivery, the less speculation about the future exists.

Closing Contracts

Ultimately, the price of a futures contract on the last day of trading must equal the spot market price (in which no speculation exists). Think about why. Speculators don’t actually want the barrels of oil. So, they will need to find someone to take them. They have three options.

First, they could accept delivery and try to sell the oil on the spot market. If the futures contract is below the spot price, this is a profitable option. That pushes the price of futures up toward the spot price. Of course, the logistics and expenses associated with doing this might not be easy to manage.

Second, they could resell the contract to a different buyer. But, anyone buying a futures contract near its expiration will need to take delivery. Therefore, the buyer wouldn’t be willing to pay more than the spot price. This pushes the value of a futures contracts toward the spot market price. If their aren’t any buyers out there, the holder of a contract could run into trouble. In fact, we actually saw traders in this position paying buyers to take oil off their hands on the last day of trading in April.

Finally, speculators could offset their position to cancel a contract. If they are the buyer on one contract and the seller on another, they can tell the exchange to void the delivery to themselves. This is how most futures contracts get settled in the US and how all contracts ultimately get settled in Europe.

Wrap-Up

The price of oil is ultimately determine by the physical market – in which oil companies and refineries enter contracts to buy and sell oil. That can happen on the spot market or through a forward contract. Forward contracts almost never use a fixed price. Rather than negotiate prices, both parties agree to let the markets determine what is fair. Then, each party can use its own hedging strategy to deal with price risk.

Futures contracts are the way companies deal with the risk that prices will change significantly in the coming months or years. Those contracts happen through a commodity exchange. However, exchanges also allow speculators to put their money where their mouth is. Their participation pulls uncertainty into the futures price far sooner than it shows up in the physical market. Most economists see this as a benefit to the market, allowing daily price movements to uncover changing risks and market conditions.

Trading futures stops about 10 days before the delivery month begins (technically, 3 trading days before the 25th of each month). A person holding a NYMEX futures contract must deal with physical delivery if they can’t close the contract by the time trading stops. Therefore, the futures market price always converges to the spot price as the delivery date approaches. Speculation never alters the true price of oil. It just updates the market to the changing risks that are present.

Now that we’ve developed an understanding of the physical market and how the futures market works, we can turn to how this all ties together for Alaska’s crude oil. Next week, we will explore how the State of Alaska determines the value of its royalties and taxes.