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Crude Oil Futures Trading 101 – What Are They and Should You Invest in Them?

By Kalen Smith

oil prices futuresWith the price of oil skyrocketing (the price recently increased by 14% in a single week), you may be wondering if now is the right time to invest in this commodity.

There are plenty of ways to get in on the oil industry. For example, you can buy stocks of oil and drilling companies. But one of the most profitable – and riskiest – investments you can make is in oil futures.

In this article, we’ll look at what oil futures are, and then discuss the pros and cons of investing in them. You can then decide if they’re a good addition to your investment portfolio.

What Are Oil Futures?

Oil futures are derivative securities that give the holder the right to purchase oil at a specified price (similar to how stock options work). If you exercise your future by the settlement date, you can purchase oil (crude oil futures trade in units of 1,000 barrels) at the price stated in the futures contract.

If the price of oil looks like it is going to continue to increase, you can also hold the future while it appreciates in value and sell it at a later date to an investor who does intend to exercise it.

Advantages of Investing in Oil Futures

Oil futures can make great investments and are probably one of the most actively traded derivatives on the market. Some of the benefits of investing in oil futures include:

  1. Ability to make substantial profits. Oil futures can be extremely lucrative investments. Some investors have been able to make tens of thousands of dollars with a single trade, while investing much less than would be necessary in the stock market. The price of oil can change substantially in a short period of time, so futures investors can see a sudden appreciation in their investment. In periods when the price of oil skyrockets, everyone would love to be able to purchase it at a lower price. Anyone who holds a future that allows them to do so is going to be in a good position.
  2. Liquidity. Oil futures are one of the most liquid investments because of the high volume that is traded every day. In fact, they are the most actively traded future on the market and hence the most liquid.
  3. Leverage. You can purchase oil futures on margin (in other words, you can borrow money to purchase them). The margin requirements are set by the exchanges and for oil they are often as low as 5% of the value of the investment. That means you could buy $100,000 worth of oil futures for only $5,000. This can also be very dangerous, but it is nice to at least have options.
  4. Limited supply. Oil is an irreplaceable resource. The fact that there is a finite supply is depressing for most people, but it can work to the advantage of investors who choose to invest in its futures. Other commodities futures such as corn and livestock can be replaced and their prices can be stabilized. However, as the world’s oil supply is exhausted, the price of oil will inevitably increase.
  5. Easy trading concept. Although it is a good idea to work with a broker or trader who can show you the ropes of futures investing, it is relatively easy to get started. Anyone who takes a little time to research the process can figure it out and develop a trading strategy.

Disadvantages of Oil Futures

Although investing in oil futures has many benefits, there are a few concerns that investors should be aware of before they get started:

  1. Volatile. All futures are volatile investments and oil is no exception. No one can predict with any degree of certainty what the price of oil is going to be tomorrow, next week, or next month. Also, changes in the value of a future tend to change significantly more than stocks. In the past year, the price of crude oil futures have risen 33%, which has been a blessing for investors. However, this shows how sensitive they are and they could easily lose the same value extremely quickly.
  2. Expiration date. All derivatives expire on a certain date. If you fail to exercise them prior to that date, they become worthless. They also lose a lot of their value as you approach the settlement date, so if you don’t intend to exercise the future it is a good idea to trade them at the earliest opportunity. Some investors want to hold onto their futures and sell them at a higher price later on, just like they would with stocks. However, they fail to grasp that holding onto the futures causes them to lose their value even when the price of oil remains unchanged. This is because the futures are less appealing to speculators who need time to exercise their strategy. Oil futures are usually listed as being good for up to 9 years, but you can buy them on the market any time before they expire. If you purchase a future within a couple of months of its expiration date, that may not leave you enough time to trade successfully.
  3. Unexpected supplies. Although the world’s supply of oil is limited, new sources are still found. Newer approaches such as offshore drilling have also increased the supply of oil. Although they have not been enough to significantly reduce oil prices, they could reduce it enough to cause futures investors to lose money on a transaction.
  4. Sensitivity to a number of issues. The price of oil is heavily influenced by many factors other than supply and demand. For example, it is often affected by the agendas of current and aspiring politicians, wars, natural disasters, and major news stories. Since the price of oil futures go hand in hand with the price of oil, these events make investing in oil riskier than many other investments.
  5. Threats from substitutes. As oil prices increase, companies and politicians look for new sources of energy. New options such as green energy become even more important as concerns for the environment and global warming increase. Alternative energy sources could drastically reduce the cost of oil if they became popular enough (i.e. less demand for oil). It is unlikely that this will happen in the near future, but it remains a threat.
  6. Exhaustion of oil. The depletion of the world’s oil supply remains a benefit for investors as it continues to drive prices up. However, one day the supply of oil will be used up completely and oil futures will obviously become worthless. This is not projected to happen for at least another forty years. However, oil consumption is rapidly increasing so we can’t be sure when the supply will be completely used up. Although this may not be an immediate problem, it is something that investors need to be wary of.

Using Oil Futures in Your Portfolio

If you decide to take the leap into oil futures, you will first need to open an online futures account (approval isn’t guaranteed). Once you’re all set up, you will need to be ready to think on your feet. Since futures expire and lose much of their value near their date of expiration, you are going to have to move quickly.

To help you make quick and intelligent decisions, it is imperative that you do your research. Analyze supply and demand charts, and consider other factors including weather patterns, political turmoil, and current events on a daily basis. All of your research should revolve around one thing: the future price of oil.

Also, oil futures provide an investment strategy even for those who believe the price of oil is going to decrease. By short selling oil futures, you are effectively betting against the future price of oil.

One other important note to keep in mind is that purchasing an oil contract gives you ownership of 1,000 barrels of crude oil. This means that for every one dollar change in the price of oil, you will have a profit or loss of $1,000. This aspect of futures even further adds to the risk and volatility of investing in oil futures.

If you forecast the trend correctly, you will find yourself in a lucrative position. But the opposite is true as well. Make sure you know what you are doing before you start investing in oil futures.

Who Is Most Likely to Invest in Oil Futures?

Many investors can benefit from investing in oil futures. They either want to use the contract in their personal investment portfolio or perhaps plan to exercise the future to lock in the price of oil. Some of the most common investors include:

  1. Institutional investors who can afford to have a short-term focus. Mutual funds, hedge funds, banks, and some other institutional investors often use oil futures in their portfolios. They are eager to take advantage of any investment with high profit potential. Some funds, such as exchange-traded funds (ETFs), may specialize in oil or energy investments. These investors can afford to have short-term assets in their portfolio and take on significant risks. However, investors who need to focus on the long-term or need to be more conservative with their portfolio are not likely to invest in oil futures (e.g. not suitable for pension funds or insurance companies).
  2. Wealthy investors. Investors with large amounts of money have the opportunity to profit from trading crude oil futures. They can afford to take the risk of losing a lot of money and are drawn to the opportunity to make large profits. They are especially interested in purchasing these futures when it looks like oil prices are going to increase significantly.
  3. Companies or organizations with oil as a major expense. Many companies have much higher expenses when oil prices increase and may purchase futures to lock themselves into lower prices. Oil is one of the biggest expenses for airlines, utility companies, refineries, and large trucking firms. They often want to hedge their risk by buying oil futures so that they can be locked in to purchase oil at lower prices, especially when they fear gas prices rising.
  4. Other oil companies. Oil companies may actually purchase each other’s futures so that they can purchase oil at lower prices than the market rate and sell it on the open market. Who is better at predicting changes in oil prices than the oil companies themselves?
  5. Individual investors. Shrewd investors are eager to pursue any strategy that gives them the opportunity to make a lot of money. However, many are hesitant to invest in oil futures due to the high level of risk involved.

When to Invest in Oil Futures

Many investors want to take advantage of oil futures but are hesitant to make the plunge. Hesitation is dangerous in this market. If you are serious about investing in oil futures, you need to understand that almost 100% of the game is timing.

First, make sure you understand the trading hours that are best suited for purchasing oil futures, which are generally between 9 am and 12 pm EST. This is the busiest and most liquid time of the day for traders with the smallest bid-ask spreads.

Secondly, get an idea of when the price of oil is likely to increase. Here are some things you should think about before you invest in oil:

  1. What is happening to the supply of oil? This is probably the most important question to ask. One of the main reasons why oil prices are spiking right now is because the world’s oil supply is becoming exhausted at an alarming rate. However, you should be aware of efforts to find new sources of oil such as through offshore drilling. This could increase the short-term supply of oil and temporarily change prices. Temporary reductions in price are extremely significant when you are buying futures that expire in a given period of time. The Organization of the Petroleum Exporting Countries (OPEC) tries to keep oil prices consistent, but they clearly have a hard time doing so. Also, OPEC nations make a lot of money selling oil, so their impartiality in keeping prices at a reasonable level may be called into question.
  2. Political developments and wars. Concerns over the wars in Afghanistan and Iraq contributed to increases in the cost of oil in 2008. Political instability has a significant effect on the price of oil, especially in countries where oil is a major source of revenue. Make sure to follow these events because changes in the price of oil are not usually far behind.
  3. Economic variables. The recession has caused many people to drive less often. Employees are even trying cut the cost of commuting to work (e.g. telecommute a couple of days a week to save money on gas). Airlines see less business as well. There is an overall decline in the demand for oil, which does affect its price. While these effects are longer term and more difficult to predict, they should be taken into account while you decide whether or not to purchase oil futures.
  4. Time of year. The time of the year has a strong impact on the price of oil. During summer months, there is a high demand for oil as people travel more. Of course, the winter is probably the biggest time when oil prices spike as consumers heat their homes and find ways to keep warm in the winter cold. Buying longer term futures prior to these months may provide an opportunity to profit when they actually come around.

Final Word

Investing in oil futures can be a great strategy. They are opportunities for investors to make a lot of money, but they are also very risky. Before you start investing in oil futures, make sure you know what you are doing. You are either going to make a lot or lose a lot in these markets. Know what affects the prices of oil and when the best time to purchase is. Even the professionals get this wrong, so be realistic with yourself before you commit to investing.

(photo credit: Shutterstock)

Kalen Smith
Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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