Energy futures are contracts for energy-related commodities: oil, gas, coal, electric power, ethanol and even uranium. An energy futures contract is a standardized agreement to exchange a specified quantity and quality of an energy-related commodity on a delivery date in the future for an agreed price set in advance. Most energy futures specify physical delivery — on the delivery date, the futures buyer will take actual delivery of, say, 100,000 barrels of oil from the contract seller. Cash-settled futures are purely financial transactions and do not involve physical delivery, but otherwise operate the same in terms of daily pricing and margin requirements as contracts for physical delivery.
In the United States, the majority of energy futures trade on the Chicago Mercantile Exchange, commonly called CME, or the InterContinental Exchange, known as ICE. The Commodity Futures Trading Commission is responsible for regulating U.S. futures trading, and sets rules to which the futures exchanges and traders must comply. Each futures exchange has a list of the particular energy futures available for trade, along with a complete set of specifications for each contract. Exchanges ensure daily payments between buyers and sellers, to reflect the change in the prices of the underlying commodities, in a process called “marking to market.”
Futures Contract Characteristics
The buyer of a futures contract agrees to accept delivery from the futures seller of a standard amount of commodity per contract. The contract specifies the quantity and quality of the deliverable asset. For instance, if the contract is for barrels of oil, it will specify the number of barrels, the type of oil — light sweet crude, shale oil, etc. — and the delivery location. The contract expiration date is the last date of the contract, and the price of the commodity at the end of that day is the final contract price.
The difference between the original agreed price of the commodity and the final price of the contract represents the profit or loss for the buyer and seller. The buyer profits if the final price is higher; the seller profits if the final price is lower. Contract expiration dates, which are pre-established by the futures exchange, range from one month to many years into the future. Other characteristics of contracts include the minimum permitted change in price at any given time, called the “tick,” and the maximum price change allowed during a trading day before trading on a contract is temporarily halted by the futures exchange.
Marking to Market
When transacting a contract, both buyer and seller must post initial “margin” money with the exchange of 5 to 10 percent of the contract value. This margin, which may need to be subsequently replenished, is used by the exchange when it marks contracts to market daily — that is, revalues contracts to reflect the current futures price of the underlying commodity. If the commodity has risen in price, the exchange moves cash from the seller’s margin account to that of the buyer. The reverse is true when the price declines. If the contract hasn’t been closed out before the end of expiration date, the exchange makes the final cash transfer, based on the closing spot, or immediate delivery, price of the commodity. Physical delivery must then occur by a specified date.
A trader, let’s call him Cliff, has formed the opinion that oil prices will decrease in the next six months, so he sells one futures contract on the CME for 1,000 barrels of oil, to be delivered in six months, for an agreed price of $70 a barrel — the contract is thus worth $70,000. Both he and the buyer must post $7,000 initial margin with the exchange, which represents 10 percent margin.
As the price of oil fluctuates over time, the exchange adjusts Cliff’s margin account by the daily change in the contract value. Since Cliff does not intend to deliver oil to the contract buyer, he closes out the contract before the expiration date — in this example for $65/barrel. Cliff’s profit is $5,000, which is 1,000 barrels times $5, precisely the loss suffered by the contract buyer. Since Cliff had to put up only $7,000 to earn $5,000, he experiences a 71.4 percent return.