It is difficult to overestimate the importance of petroleum to even the most primitive contemporary economies. There is no material that provides greater energy per unit of extraction cost. Oil, since it is abundant and proven, will most certainly continue to be the most popular energy source on Earth for some time.
Oil trades in a complex market with various methods and vehicles for trading or speculating in oil, with the International Energy Agency predicting overall consumption at 91.9 million barrels per day in 2020.
Trading in oil futures is one technique to speculate on oil prices.
- Oil, which is abundant and proven, will most certainly be the most popular energy source on Earth for some time to come; investing in oil futures is one method to speculate on oil prices.
- Oil contracts’ increased frequency and regularity make it simpler for investors to identify patterns, or projected movements, in the future price of oil.
- There are endless factors that influence the ultimate price of oil, but our brains can only consider the most evident ones, such as the present price of oil.
- To trade oil futures, you must have two opposing characteristics: patience and aggressiveness (in addition to a large cash flow).
How Do Oil Futures Contracts Work?
In principle, oil futures contracts are straightforward. They maintain the time-honored practice of some market players selling risk to others who willingly acquire it in the expectation of profit. To put it another way, buyers and sellers agree on a price at which oil (or soybeans, or gold) will trade not today, but on some future date. While no one knows what price oil will be selling at in nine months, futures market participants think they can.
Assume that Commodity X, which is presently selling for $30, will be available for $35 in a contract due next January. A speculator who believes the price will rise over that level, say to $45, by that time may buy the $35 contract. If their guess is true, they may purchase X at $35 and sell it immediately for a $10 profit. However, if X falls short of $35, their contract is worthless.
Again, for some investors, the futures contract is a method to lock in a price of $35 in the future; for them, one in the hand is better than two in the bush, even if X goes to zero. People on the opposing side of the transaction believe in a different axiom: nothing risked, nothing gained. If X rises to $100 or even $200, the speculator who bet on X settling at $35 will profit many times over. The price at which the commodity in issue is likely to sell on the later date is obviously referred to as the “futures” price, and it might change significantly from today’s price.
Unlike most agricultural commodities, oil futures settle monthly. Other futures contracts, for example, may only settle four times a year. Oil contracts’ increased frequency and regularity make it simpler for investors to identify patterns, or projected movements, in the future price of oil.
Oil was pricing at under $40 per barrel in September 2020, which was more than $100 less than the peak price. Oil was pricing at $60 per barrel in December 2019. Demand in certain parts of the globe has rebounded, while forecasts for 2021 have been revised to account for aviation industry downturn. The worldwide demand for oil is expected to reach 97.1 million barrels per day in 2021. Product inventories are quite high over the world.
At the same time, greater drilling in the United States has reduced the relevance of international cartel threats and maneuvering. What should a futures investor do in light of this? Assume that prices will continue to decline in the short run, or believe that we are reaching the moment when prices will meet production costs, with no other option but to rise?
Can You Predict the Future Through Futures?
November 2020 futures contracts are trading for $40.25 in October 2020. The next month’s—December 2020—is at $40.53; January 2021 is at $40.88; February 2021 is at $40.22; and two years from now, oil prices (or, at least, oil prices as anticipated by futures contracts) are expected to reach $43.46 per barrel. The upward trend does not end there. After two years, oil futures settle semiannually or even annually rather than monthly. The most recent available contract, for 2031, is priced at $50.34.
First, anticipating market movements more than ten years in advance is akin to predicting the weather or the result of the Super Bowl that long in advance. The New England Patriots might be contenders in 2031, or they could finish 1-15: the great bulk of the team’s players are unknowns, now playing in college or even high school.
The world of 2031 will not be similar enough to the present to justify forecasts. Nonetheless, the oil futures market for 2031 remains, despite the fact that history has shown that projecting prices so far in advance is a risky game.
Only Hindsight Is 20/20
Let’s look at what the futures market projected oil prices will be in 2015 in September of 2010. December 2015 oil futures were selling at $89 at the time. So why not? $89 suggested a number similar to the then-current $76 per barrel oil price, plus a few dollars to predict the continuance of a growing trend. This makes complete sense. Except that no one, or at least not many people, predicted that rising supply would push oil prices down to levels seen in 2015.
Of course, if enough people had predicted it, the futures price would never have reached anywhere near $89 in the first place. There are endless factors that influence the ultimate price of oil, but our brains can only consider the most evident ones, such as the present price of oil. We can look a month or two ahead with some precision, but predicting what oil will do after four more Olympiads and another presidential election or two is a complete crapshoot.
There are few guarantees in the market, but here’s one that even Investopedia’s typically cautious legal advisers would support: The real price of oil will be significantly more volatile than the relatively narrow range of prices represented by futures contract movements. A steady hike to $50.67, with a $45 floor? Don’t put your money on it. How can we be so certain?
For one thing, the futures trend is only one way. Every change, no matter how little, is a good thing. Sure, oil prices may climb steadily over the next eight years with no decreases, but it has never done so in any prior period of that length, and common sense says that it wouldn’t.
The Bottom Line
To trade oil futures, you must have two opposing characteristics: patience and aggressiveness. A significant bankroll is also required to begin started. Oil futures contracts are measured in thousands of barrels rather than barrels. That December 2031 future will cost you $50,670, but it will provide you with a liquid asset whose value will undoubtedly change between now and when it matures. That means you have plenty of time to either make a profit or wait and worry whether you made a mistake. In any case, trading oil futures is not for amateurs.
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