Energy prices can be extremely volatile, due to the fact that energy is possibly the most tactical and political product in the world. The price of energy affects not only industries, but nations, as well. In this article, we will explore how the energy market influences almost everything that we do.

Key Takeaways

  • Energy futures are standardized financial contracts that have a value based on an underlying energy product, such as oil, natural gas, or electricity.
  • Investors, speculators and hedgers trade energy futures on exchanges such as the Chicago Mercantile Exchange (CME).
  • Commodities are seen as a portfolio diversifier and may provide some protection against inflation.
  • Companies that produce and/or use energy will often use these futures to hedge against future price uncertainty.

What Are Energy Futures Contracts?

An energy futures contract is a legally binding agreement for delivery of crude, unleaded gas, heating oil or natural gas in the future at an agreed upon price. These futures contracts are standardized by an exchange such as the New York Mercantile Exchange (NYMEX) or Chicago Mercantile Exchange (CME), as to quantity, quality, time and place of delivery. Only the price remains variable in the market.

Futures contracts offer speculators a higher risk/return investment vehicle because of the amount of leverage involved with commodities. Energy contracts in particular are highly leveraged products. Because they are standardized and trade at a centralized exchange, futures contracts offer more, financial leverage, flexibility, and financial integrity than trading the actual commodities themselves in the spot market or using OTC forward contracts.

For example, one futures contract for crude oil controls 1,000 barrels of crude. The dollar value of this contract is 1,000-times the market price for one barrel of crude. If the market is trading at $60/barrel, the value of the contract is $60,000 ($60 x 1,000 barrels = $60,000). Based on exchange margin rules, the margin required to control one contract is only $4,050. So, for $4,050, one can control $60,000 worth of crude. This gives investors the ability to leverage $1 to control roughly $15.

Contract Specifications

Energies are traded at several different exchanges around the world, for example, in London, Chicago, and now internationally at the all-electronic Intercontinental Exchange (ICE). Here, we will only look at some of the contracts traded at the New York Mercantile Exchange (NYMEX).

Crude Oil

Crude accounts for 40% of the world's energy supply, and is the most actively traded commodity contract worldwide. Crude is the base material that makes gas, diesel, jet fuels and thousands of other petrochemicals.

More specifically, the type of crude in question is the light sweet crude oil variety, which, according to NYMEX, contains lower levels of sulfur. This type of crude is traded in dollars and cents per barrel, and each future contract involves 1,000 barrels. As in the example above, when crude is trading at $60/barrel, the contract has a total value of $60,000. For example, if a trader is long at $60/barrel, and the markets move to $55/barrel, that is a move of $5,000 ($60 – $55 = $5, $5 x 1,000 bl. = $5,000).

The minimum price movement, or tick size, is a penny. Although the market frequently will trade in sizes greater than a penny, one penny is the smallest amount it can move.

Crude has a daily limit of $10/barrel, which is expanded every five minutes as needed. This means crude will never have an upper or lower lock limit. Remember, a $10 difference in a barrel of oil is a move of $10,000 per contract.

The requirements of the exchange specify delivery to numerous areas on the coast and inland. These areas are subject to change by the exchange. For example, currently for the NYMEX, the delivery point is in Cushing, Oklahoma.

Because energy is in such demand, is it deliverable all 12 months of the year. To maintain an orderly market, the exchanges will set position limits. A position limit is the maximum number of contracts a single participant can hold. There are different position limits for hedgers and speculators.

Heating Oil

According to NYMEX, heating oil accounts for 25% of the yield of a barrel of crude, and is the second-largest yield after gas. Heating oil futures are used by a wide variety of businesses to hedge their exposure to energy cost.

Heating oil is traded in dollars and cents per gallon. One contract of heating oil controls 42,000 gallons, or one rail car. When the price of heating oil is trading at $1.5000/gallon, the cash value of that contract will be $63,000 ($1.5000 x 42,000 = $63,000).

The tick size is $0.0001 per gallon, which equates to $4.20 for each contract. For example, if one was to go long at $1.5500 and the markets moved to $1.5535, one would have a profit of $147 ($1.5535 - $1.5500 = $0.0035, $0.0035 x 42,000 = $147). Conversely, a move to $1.5465 would equal a loss of $147. Heating oil's daily limit is 25 cents, which is $10,500 per contract.

Heating oil contracts are deliverable for 18 consecutive months, and the delivery point is at New YorkHarbor.

Heating oil, like crude, also has position limits set by the exchanges, which are no more than 7,000 contracts in total, and no more than 1,000 contracts during the last three days of the current month.

Unleaded Gas (RBOB)

Gasoline is the single largest refined product in the U.S. and accounts for half of the national consumption of oil. Besides the large demand for gas, there are numerous of other factors, like government laws, which can affect the price. Reformulated gasoline blendstock for oxygen blending (RBOB) is a newer blend of gas which allows for 10% fuel ethanol.

Gas is traded in the same 42,000-gallon (1,000 barrels) contract size as heating oil. It is also traded in dollar and cents, so if the market is trading at $2/gallon, the contract will have a value of $84,000 ($2 x 42,000 = $84,000). Like the rest of the energies, this is a high dollar value contract and is quite leveraged. The daily limits here equate to a move of $10,500 per contract or 25 cents/gallon.

The minimum tick size is $0.0001, or a total of $4.20 for each contract. So any 10-cent move in unleaded gas will equate to either a gain or a loss of $4,200.

Gas is deliverable all year-round; it has position limits and the delivery point usually takes place at the future seller's facility.

Natural Gas

According to the U.S. Energy Information Administration, about 25% of the total energy consumption in the United States is natural gas. Within the 25%, about half is used by industry, while the other half by commercial and residential users. Natural gas is one of the bigger futures contracts that are traded worldwide. One contract equals 10,000 MM Btus (million British thermal units). If the current market price is $6 per MM Btus, the contract has a value of $60,000 ($6 x 10,000 MM Btus = $60,000).

The minimum tick is $0.001, or $10 per tick per contract. For example, let's say you buy a contract of natural gas when the market is at $6, and then sell it at $7. In this transaction, you would have made $10,000 on the $1 move in natural gas.

Like other energies, natural gas is deliverable all year round and has position limits. The delivery point for natural gas traded on the NYMEX is at the Sabine Pipe Line Company's Henry Hub, which is located in Louisiana.

Hedgers and Speculators

The primary function of any futures market is to provide a centralized marketplace for those who have an interest in buying/selling physical commodities at some time in the future. The energy futures market helps hedgers reduce the risk associated with adverse price movements. There are a number of hedgers in the energy markets because almost industrial sectors uses energy in some form. The energy complex is quite volatile and takes quite a bit of capital to get involved, although there are new e-mini contracts available, which are growing in volume month by month.

The Bottom Line

It is important to note that trading in this market involves substantial risks and is not suitable for everyone - only risk capital should be used. Any investor could potentially lose more than originally invested.