Oil Futures Contracts – What Are They & How Do They Work?
Crude oil is one of the most in-demand commodities in the world. However, allocating funds directly to this asset may not be suitable for every investor. In this regard, you can consider trading through oil futures.
Find out more about this investment vehicle by reading this blog.
What Are Oil Futures Contracts?
Oil futures are derivatives contracts that let you buy or sell a set amount of oil at a specific price and date.
Investors generally use these types of agreements to bet on the future prices of crude oil and gain profits based on their assumptions. These contracts are settled on a monthly basis and their regular frequency assists traders to anticipate the future prices of crude oil. Thus, they are able to make investment decisions.
Moreover, before taking delivery of the asset, investors usually liquidate their position or roll over their positions. To track the price of crude oil, investors use two international benchmarks, where the prices usually move in tandem.
- North Sea Brent Crude which trades on the Intercontinental Exchange in Europe, the Middle East, and Africa
- West Texas Intermediate (WTI) which trades in North America on the New York Mercantile Exchange (NYMEX)
How Do Oil Futures Work?
The price of an oil futures contract depends upon the anticipated future value of the underlying asset i.e., crude oil. So, if traders feel that the price will move up, the contract value will increase and vice versa.
Apart from retail investors, oil futures are generally used by large corporations as well as countries to hedge against the price fluctuations of crude oil in the international market. Moreover, these contracts are essential to them as a large quantity of crude oil barrels are involved per transaction.
Apart from these aspects, almost all the countries in the world depend heavily on oil imports. Thus, if crude oil prices appreciate, they have to pay more in order to meet their domestic demands and strain their finances. This is another big reason why countries use this derivative asset as a hedge.
Furthermore, oil futures are also used by speculators who seek to take advantage of the price movements in order to secure gains.
Factors Affecting Crude Oil Prices
if you plan to enter the market of oil futures, it is crucial for you to know the factors influencing the price of crude oil. Some of them are as follows:
- US Dollar Value
As the USA is one of the biggest countries involved in the trading of crude oil, the value of its currency plays a major role in determining this commodity’s price. Thus, whenever you notice a significant change in the US Dollar’s value, you can expect a fluctuation in crude oil prices soon to follow.
- Demand and Supply
The market forces of demand and supply also play a vital role in determining the price of crude oil. In addition, rising interest rates, production costs, storage capacity, etc., also come into play while determining crude oil prices.
- Natural Disasters and Geopolitical Events
Any major natural disaster or geopolitical conflict in the world’s leading oil-producing nations will have a massive impact on the value of crude oil. For instance, due to Russia’s invasion of Ukraine, global crude oil prices have appreciated significantly.
- Announcements by OPEC
OPEC stands for the Organisation of Petroleum Exporting Countries. It consists of the world’s largest oil-producing countries. Now, when this entity makes any major announcement, they have the capacity to affect investors’ sentiments and cause a short-term fluctuation in crude oil prices.
Benefits of Trading Oil Futures
Here are some of the benefits of investing in oil futures:
- High Liquidity
Currently, crude oil is one of the most in-demand commodities. Thus, when you enter into an oil futures contract, there is no dearth of liquidity. There are always enough buyers and sellers of this contract, allowing you to exit your position with ease.
- Low Margins
Generally, for trading oil futures, the margin requirements are low. In India, the margin requirements are usually around 5%, enabling you to use a considerable amount of leverage. This allows you to open a position with little investment and stand the chance of gaining huge profits.
- Increasing Worldwide Demand for Energy
A significant benefit of oil futures investments is that the global demand for energy is increasing at a rapid pace. Moreover, crude oil being a fossil fuel has limited supply, and thus with increasing demand, its price will fluctuate, thus increasing your chances of securing gains.
How to Trade Using Oil Futures Contracts?
In India, you can trade oil futures on the Multi Commodity Exchange (MCX). Here, the lot size for the crude oil futures contract is 100 barrels and Crude Oil Minis are 10 barrels.
Now, there are two ways you can buy crude oil futures:
- Investing Directly on the MCX
To trade using oil futures, you can directly invest in these assets on the MCX. For doing so, you will need to open a futures trading account on your preferred brokerage platform. Then, you will be able to place orders for futures contracts just like equity stocks and other securities.
- Purchasing Oil ETFs
If you want to opt for an indirect form of investing, you can allocate your funds to Exchange Traded Funds (ETFs) that deal with purchasing and selling of oil futures contracts. Investing in these schemes may involve minimal fees; the fund managers actively monitor market movements to enhance investors’ profits.
The high volatility of oil prices can make trading oil futures a bit risky for those who are new to this market segment. Moreover, this trading strategy depends upon future price movements of crude oil. Thus, it is advisable to develop a clear perception of crude oil price movements before you make an investment.
Do I need a Demat account for trading oil futures?
Yes, you need a Demat account for trading oil futures. It acts as a storage for holding the derivatives instruments in which you have invested.
Can I exit oil futures contracts before the expiration date?
Yes, you can exit your oil futures contracts before expiry. The profits or losses that you may have realized will be adjusted by your broker from your deposited margin.
What is the best way to keep a track of the crude oil industry?
The best way to follow the crude oil industry is to keep a note of the daily prices of crude oil, follow news related to the oil market online and stay aware of the factors that affect crude prices.
Which body regulates commodity futures in India?
The Securities and Exchange Board of India (SEBI) is the entity regulating commodity derivatives trading in India.