When we learn that oil futures are $60 a barrel, what does that really mean? Who pays the sixty dollars to whom, and when?
Buyers and sellers in the futures market for oil include hedgers and speculators. Hedgers are those who really want to buy and sell oil but want to minimize the risk of price changes. Speculators don't want to really buy or sell oil.
Hedging in oil futures markets is the act of buying and selling financial claims in order to protect against the risk of fluctuations in oil prices. Hedging does not eliminate risk but transfers it to a speculator. Speculation is the purchase or sale of oil futures contracts when the investor is not actually in the oil business. Speculators hope to profit from changes in market prices.
In the oil futures markets investors can enter into a:
- Short hedgeand buy futures contracts to sell oil. This protects hedgers against the risk of falling oil prices. Speculators profit from falling oil prices.
- Long hedge and buy futures contracts to buy oil. This protects hedgers against the risk of rising oil prices. Speculators profit from rising oil prices.
Hedging in the futures markets involves opposite positions in the spot (i.e., today's cash market) and futures markets. The profit on the futures contract will (partially) offset the loss in the spot market. A profit in the spot market would be offset by a loss in the futures market. All of this trading takes place at the New York Mercantile Exchange.
Here is an example of a short hedge. Suppose today’s spot market price is about $60. The February 2006 futures price at the NYMEX is about $64. If you need to sell oil in Feb/06 and are worried that the price of oil will fall below $64, you can buy a futures contract today to sell in Feb/06 at $64 (“sell short”).
Suppose you were right about the price movement and the Feb/06 spot price is $62. You would sell the actual oil in the spot market at $62 and take a loss relative to the August/06 price. To settle the futures contract you would sell at $64 and buy at $62 and make a profit to offset your loss in the spot market.
Suppose you were wrong about the price movement and the Feb/06 price is $68. You would sell the actual oil at $68 in the spot market and be better off relative to August/05 because the price rose. But what to do about that stupid futures contract? You would settle the futures contract by buying at $68 and selling at $64 and taking a loss. The gain and loss offset each other.
Here is a long hedge example. Again, today’s spot market price is about $60. The February 2006 futures price is about $64. If you need to buy oil in Feb/06 and are worried that the price of oil will rise above $64, you can buy a futures contract today to buy in Feb/06 at $64 (“buy long”).
Suppose you were right about the price movement and the Feb/06 spot price is $66. You would buy the actual oil you need in the spot market at $66 and be worse off relative to August/06 because the price rose. To settle the futures contract you would buy at $64 and sell at $66 and make a profit to offset your loss.
Suppose you were wrong about the price movement and the Feb/06 price is $58. You would buy the oil at $58 in the spot market and be better off relative to August/06 because the price fell. But there is still that pesky issue of the futures contract. You would then settle the futures contract by buying at $64 and selling at $58 and taking a loss. The gain and loss offset each other.
Speculators never actually buy or sell oil in the spot market. They guess about future price movements and enter into futures contracts in order to profit from the movement.
