Oil Futures Explained
Oil futures contracts are a derivative financial instrument that represents an agreement to buy or sell a specific amount of oil at a specific price by a certain date. Oil futures are used by investors to speculate on the future direction of the price of oil, or by physical producers of a commodity to hedge the risk of ownership. Most futures contracts are closed out before expiration.
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Crude Oil Futures
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One of the most popular oil futures contracts is the light, sweet crude oil contract that trades on the New York Mercantile Exchange (NYMEX). Light and sweet are terms that refer to the low sulphur content of certain grades of crude oil. Each contract represents 1,000 barrels of oil, or 42,000 gallons, and is priced in dollars. Other futures contracts traded on the NYMEX include Brent Crude Oil and Russian Export Blend Crude Oil.
Short Hedge
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One popular strategy in the oil futures market is called a short hedge, which is used by physical producers to protect the value of the oil inventory that they own. Here's an example: An individual has an oil well that produces 1,000 barrels per day, and wants to hedge her monthly production and ensure that she receives $100 a barrel for the crude. She will sell 30 oil futures contracts at $100 per barrel. If the price of oil moves higher than $100 a barrel, she will close out the futures contract at a small loss that is offset by the higher receipts from the sale of the physical oil. If the price of oil moves down, the profit realized when closing out the futures contracts will offset the lower receipts from the actual sale of oil.
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Long Speculative
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A long speculative position might best be illustrated with this example: An analyst at a hedge fund feels that the oil inventory report due out later in the week will show a large drop in inventories rather than the increase that the market is expecting. He buys 30 oil futures contracts at $100 a barrel. After the inventory report is released, his analysis was correct and the price of oil goes to $104 a barrel. He sells the contracts to close out his position and realizes a profit.
Regulation
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The Commodity Futures Trading Commission (CFTC) regulates futures trading in the United States, and was created in 1974 with the passage of the Commodity Futures Trading Commission Act. The CFTC consists of five members appointed by the president of the United States, and approved by the senate.
CFTC Controversy
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The CFTC has received criticism for failure to control the degree of speculation in the oil futures market, which some market observers blame for high oil prices. The controversy is unresolved as of 2009, with the counterargument attributing high oil prices to strong demand and weak supply growth.
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