What are crude oil futures, and should I invest in them?
Oil is one of the most hotly debated assets on the market, and for good reason. There’s quite a bit going on in the industry.
On one side, there’s a major push to discontinue the use of fossil fuels and move toward a green energy infrastructure, which would ultimately reduce demand and oil prices.
On the other hand, many argue that oil isn’t going anywhere any time soon, and with energy consumption at all time highs, there’s plenty of room for the asset to gain in value.
With such a debate surrounding the asset, it only makes sense that crude oil prices are consistently rising and falling, creating opportunities for investors. But how do you go about investing in crude oil?
What Are Crude Oil Futures?
Surely, you’re not going to go to the market, buy a few thousand 55-gallon drums full of crude oil, and store it in your backyard. That’s just impractical.
That’s where trading futures come into play.
Crude oil futures contracts were designed as a way for both oil companies and companies that consume a lot of oil to schedule the delivery of the commodity at a specific price and predetermined date. Today, these contracts also are traded between speculators who hope to exploit the volatile nature of the commodity for a profit.
These derivatives are a hot commodity on the futures market, offering up the potential to generate significant gains in a short period of time. Unfortunately, when the wrong moves are made, the declines can be just as significant.
Most oil futures contracts represent the purchase and sale of 1,000 barrels of oil. When the contract is purchased, it specifies the delivery of these barrels of oil at a predetermined date (up to nine years away), or expiration date, for a predetermined price.
For example, let’s say you entered an oil futures contract today with a three-month expiration date; it would mean that you’re due delivery of 1,000 barrels of oil three months from now, but you would pay today’s price — for example’s sake, let’s say $50 per barrel.
In 30 days, you see that the price of oil has risen to $51 per barrel, meaning your futures contract is now worth $1,000 more than you paid for it. On the other hand, if the value of oil were to fall to $49 per barrel, you would have been handed a $1,000 loss.
Either way, you’ll want to sell well before the contract expires. Typically individual investors and price speculators who aren’t industrial-scale users of crude oil close out futures contracts well before they reach expiration.
There are two reasons you wouldn’t want to hold the contract to expiration:
- You Probably Can’t Store 1,000 Barrels of Oil. Chances are you don’t have adequate space to store 55,000 gallons of oil. If you’re the owner of the contract at its expiration, you’ll need to figure out where to store the oil and what to do with it. If you choose not to take possession, your entire investment is lost.
- Futures Contracts Lose Value Near Expiration. The futures market moves at a very fast pace, with the excitement being predicting what happens in a week, not what happens when the contract expires. As the contract nears its expiration date, the premium paid for potential growth in value is minimized. So, you’ll limit your potential gains by holding these contracts too long.
Pro tip: If you’re looking to invest in oil futures, you’ll want to consider opening an account with a broker that offers future contracts. TradeStation is offering a signup bonus of up to $5,000 when you open an account.
Advantages of Investing in Oil Futures
There are several reasons an investor would be excited about trading oil futures. Some of the biggest benefits include:
Sure, the world is working to shift away from burning fossil fuels, but that doesn’t mean it’s happened yet. Oil is one of the most in-demand commodities in the world, meaning that if you’ve got some to sell, there’s a buyer waiting to hand you cash.
When trading oil futures, there will be no shortage of liquidity when it’s time to exit your position, meaning you’ll never be stuck holding onto worthless paper.
Oil prices fluctuate rapidly. Although this will add to the level of difficulty when trading futures, it also adds to the level of potential profitability, with winning trades yielding eye-opening returns.
Crude oil can be traded using margin accounts with cash holding requirements as low as 5%. This means that with just $5,000, you’ll be able to buy $100,000 in oil futures contracts, helping to further increase your potential profitability.
4. Easy Accessibility
The futures market is relatively straightforward, with fewer moving parts to consider than the stock market. With a little research, you’ll be able to understand the ins and outs and develop a strategy that helps you meet your investing goals.
5. Oil Supplies Won’t Last Forever
One of the biggest draws to oil is the idea that prices will have to go up in time. As the global demand for energy, plastics, and other petroleum products continues to surge, so too will demand for this commodity, which is in limited supply.
Oil is formed from the carbon in ancient organic matter buried under significant heat and pressure for many millions of years. It can’t be made in a lab. The law of supply and demand suggests the value of oil should continue to head upward over time.
Disadvantages of Investing in Crude Oil Futures
Oil futures are an exciting asset to trade, but don’t let them fool you; they’re not for everyone. Before diving in, it’s important that you understand the dangers associated with trading these assets:
1. One Contract Represents 1,000 Barrels of Oil
With one contract representing 1,000 barrels of crude, a $0.50 decline in the price of a barrel of oil means a $500 loss to the investor. At the same time, volatility is commonplace in any market that’s centered around a high-demand commodity like oil.
The mix of high volatility and small price movements mean either big gains or big losses — a risky prospect.
Most oil futures traders take advantage of margins, shelling out far less actual cash than the value of the oil futures they’re purchasing. Although the increased potential gains associated with borrowing money to invest are exciting, the potential downside is a pill that’s difficult to swallow.
The declines experienced on these investments are just as dramatic as the gains, meaning painful losses can happen very quickly.
3. Futures Expire
When buying a share of stock, you own that share until you decide to sell it, and it has some value whether the stock price is higher or lower than it was when you purchased it.
By contrast, If you fail to sell or execute a futures contract by the time it expires, you’ll be left holding a worthless piece of paper.
4. Unknown Supplies
The supply of oil on Earth is finite, but the extent to which it’s limited is still unknown.
There are countless oil exploration companies that are centered around finding yet-unknown supplies of oil buried deep within the Earth’s crust, and every once in a while, you’ll hear about a successful discovery. Large discoveries will generally lead to fear of increasing supply, which could send the price of oil down.
5. Going Green
With an increasing population, there’s an increasing demand for energy, but that doesn’t mean the energy has to be provided through the burning of fossil fuels.
Some oil investors have an idea in their minds that green energy will never be able to replace the need for crude oil, and they may be right. But the extent to which oil may be necessary to power the world as soon as 10 years from now might be substantially lower.
Every time you hear about the next generation of electric car, solar panel, or hydrogen fuel cell, you’re hearing about technology that could drive a substantial decrease in the demand for crude oil.
What Causes Movement in Oil Futures?
Any time you decide you’re going to start trading a new asset, it’s important to get an understanding of what causes movement in the value of that asset. Oil is no different.
Some brush off oil’s price movements as a simple balance between supply and demand. When supplies are up and demand is down, prices must fall, and vice versa, but in reality, the factors that determine the price of crude oil are much more complex than that. Here are the most significant:
Black Swan Events
In the stock market, black swan events — unforeseen events that cause significant price movements — are rare, but they do happen. In the crude oil space, these events are far more common.
Any event that leads to an increase in the supply of oil or a decrease in the global demand for the commodity will result in price movements.
If an exploration team happens to find a large deposit of oil, it’s a major win for them, but not necessarily a great thing for the oil investor who banks on a limited supply. The coronavirus pandemic, which led to dramatically reduced demand for travel, was another black swan event that sent oil prices down the tubes.
OPEC Decision Making
The Organization of Petroleum Exporting Countries, or OPEC, is the world’s largest oil cartel, consisting of 13 member countries that produce about 40% of the world’s crude oil. With such a stronghold on the production of the commodity, investors pay close attention to what OPEC is doing, and for good reason.
When the price of oil falls too fast, OPEC often decides to limit production, constraining supplies and resulting in price appreciation.
On the other hand, if the price of the commodity rises too fast, the cartel increases production and exports from member countries, resulting in a flood of supply and helping to taper off the increasing price of oil.
Considering the extent of OPEC’s role in the pricing of crude oil, it’s important that investors pay close attention to what the cartel announces with regard to production levels.
In the stock market, you’ll often hear terms like “prices change with the weather,” but that’s a figure of speech. When it comes to oil, the weather actually plays a significant role in the prices consumers are willing to pay.
After all, in extreme winters, demand for heating oils will climb. When summer temperatures rise to extremes, consumers use more electricity to power their air conditioners, also leading to increases in demand for energy and, ultimately, growth in the price of the oil.
The effects of climate change are becoming so serious that they’re impossible to ignore. Hurricanes in the Southeast seem to be becoming more frequent and intense, while wildfires in California are doing the same. At the same time, a record heat wave recently ravaged the Northwest, and drinking water reservoirs are beginning to dry up.
And the United States isn’t the only country experiencing this.
That’s a major issue, and it’s the reason regulatory changes are starting to be made globally, with multiple countries vowing to ban the use of on-road combustion engines by 2035 while making other changes to shift away from the burning of fossil fuels.
As this trend continues, demand for oil has the potential to fall off a cliff, resulting in declines in value.
Geopolitical conditions play a significant role in the supply-and-demand equation when it comes to oil, especially when these conditions are associated with countries known for high levels of oil production.
For example, according to the United States Energy Information Administration (EIA), Iran accounted for about 12% of the global oil reserves and 25% in the Middle East. However, that supply is largely restricted from making it to the U.S. and several other countries due to sanctions imposed on Iran as a result of its nuclear activities.
Should sanctions be lifted and Iranian oil becomes available to the U.S. and other Western countries, supply would increase substantially, which could lead to declines in price.
On the other hand, unstable conditions in the Middle East raise concerns of supply shortages, often leading to a reduction in supply and increased prices. For example, a 2020 attack on Saudi Arabia’s Abqaiq plant, responsible for about 5% of the global oil supply according to The New York Times, led to a rise in oil prices in September 2019.
Finally, the state of the economy, both in the U.S. and around the world, plays a major role in the price of oil. After all, when the economy enters a rough patch and consumers are concerned about their ability to survive financially, spending slows significantly.
If consumers aren’t willing to spend, they have no reason to drive to stores, restaurants, and other locations. Instead, they’re more likely to stay home. For those hit hardest by economic blues, consumers may be forced to change their energy consumption habits along with their travel habits.
That’s bad news for the oil industry, leading to declines during economic recessions.
On the other hand, when the economic outlook is positive, travel, energy consumption, and overall spending tend to rise. As this increase in spending takes place, demand for oil rises, generally leading to increasing prices.
How to Buy and Sell Crude Oil Futures
There are a few ways to go about getting your hands on crude oil futures. Some of the most common include:
- Buy Oil Futures Directly. Your first option is to buy and sell oil futures directly through a commodities exchange. Some of the most popular are the New York Mercantile Exchange (NYMEX) and the Chicago Mercantile Exchange (CME or CME Group). You can also purchase through a broker like TradeStation.
- Buy and Sell ETFs. If you’d rather let someone else take control of the buying and selling of oil futures while paying minimal fees, you can invest in oil-related exchange-traded funds (ETFs). However, make sure to dive into the details of the fund you buy. While some of these funds invest in oil futures and other oil-related derivatives, others invest in oil production companies, giving you no direct exposure to physical oil.
Regardless of how you choose to gain access to the futures industry, there are a few things you should keep in mind:
- Rapid Price Changes. Oil futures prices are known for heavy levels of volatility. As a result, it’s imperative that you strictly follow your trading strategy, even if that means accepting a loss from time to time — a painful reality all investors will have to come to grips with.
- Daily Research Is a Must. There are several factors that cause the price of oil to move, and each of them can lead to wide swings in value on their own. Not only is daily research a must, it’s crucial that you follow the news, not only monitoring what oil is doing at the moment, but the state of geopolitical and economic conditions, weather events, and other factors mentioned above.
- Avoid Margins Until You Know What You’re Doing. As a beginner, the allure of the dramatic gains successful margin trades can provide is hard to ignore. However difficult it may be, you should avoid trading on margin until you become an experienced oil futures trader. Sure, the potential for jaw-dropping gains is there, but there’s also the potential for significant losses.
Crude Oil Benchmarks
There are several different blends of oil out there, each with a different sulfur content, weight, and value. Oil benchmarks are used to compare and evaluate the value of other types of oil.
The most commonly used benchmarks are Brent Crude Oil, Dubai Crude, and West Texas Intermediate (WTI).
These benchmarks are important because more than 200 varieties of oil are traded on the global market. Being the most popular, these benchmarks establish an initial price reference, or baseline, to use when evaluating and trading individual oil varieties.
For example, heavy oil from Saudi Arabia is less expensive than the lighter WTI, because it yields less gasoline and diesel fuel when refined. As a result, traders will compare the price of the oil from Saudi Arabia to the WTI to determine whether it is over- or undervalued.
Who Should Invest in Crude Oil Futures?
While oil futures trading may seem like a relatively simple way to go about making money in the market, it’s a risky investment option that’s suitable for a select group of market participants. Those who are most likely to take part in this type of trading include:
Institutional investors like hedge funds, mutual funds, and banks are some of the most active traders in the oil futures market. These investors have the deep insight and analytical skills required to be successful.
Moreover, they have the bankroll and risk tolerance that allows them to withstand the blow when a trade goes wrong. The average individual investor doesn’t have the risk tolerance it takes to be comfortable trading these assets.
As with institutional investors, high-net-worth investors spend quite a bit of time in the market and often have a high risk tolerance due to their understanding of the complexities of finance.
As a result, it’s common for oil futures to be part of a highly diversified portfolio held by a high-net-worth investor.
Oil companies are known for purchasing futures from one another in an attempt to obtain oil at a lower price. When the contract expires, if their prediction was correct, the oil company will be able to generate a profit by selling the oil at a higher price once it’s delivered.
Considering their inside knowledge of the market, oil companies have an uncanny ability to predict the future of the commodity’s price.
Heavy Consumers of Oil
Airlines, transportation companies, refineries, and a long list of other companies are highly dependent on oil, realizing decreased profits when oil prices are high and reduced costs when prices are low.
As a result, these companies often purchase oil futures in an attempt to stabilize costs when the price of the commodity is headed up.
Finally, while oil futures aren’t suited for most investors, young investors with a healthy appetite for risk often find their way to the futures market in hopes of striking it big.
It’s OK to dabble in a high-risk, high-return asset from time to time, but you should never risk more than 5% of your total portfolio value on high-risk assets like oil futures.
At first glance, trading crude oil may seem like the perfect way to strike it big in the market. However, things aren’t always as they seem. While there are plenty of people making money in the space, the highly volatile nature of the industry makes it incredibly risky.
The reality is that this type of trading is best for those with deep pockets and a high risk tolerance.
If you’re taking the slow-and-steady approach to wealth, investing over the long run, and you’re not interested in significant risk, speculating is generally not the way to go.
Nonetheless, if you decide to try your hand in the oil futures market, be sure to limit your exposure to 5% of your overall portfolio’s value and stay on top of your investments with consistent research.