By Mario Reyna
As originally published in Texas Border Business newsprint edition May 2020.
I am sure many of you have seen the headlines in recent weeks about the oil market: Free Fall: Oil Prices Go Negative, or Oil Plunges Below Zero for First Time in Unprecedented Wipeout.
So, the question is, why did this happen? Oil is a commodity that is traded widely across the world in places such as the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), or Intercontinental Exchange (ICE). The price of oil determines the cost of some products that we use daily such as gasoline, diesel, and jet fuel.
Oil is traded in these exchanges as a futures contract of 1,000 barrels or 42,000 and gallons of black gold, Texas tea, as ‘Jed’ Clampett would say before he moved to Beverly Hills. However, what is a futures contract?
A futures contract is a legal agreement between two parties – the seller and the buyer -where the seller agrees to deliver a commodity (oil) on a specific date for a certain price to the buyer. Businesses get involved in a futures contract because they want to plan their cash flow requirements and other factors that impact their balance sheet. They are hedging which means limiting the probability of loss due to price fluctuation.
Investors and speculators get involved in cash-only contracts because they want to participate in this very lucrative market. Whatever you buy on a Futures contract, it will be delivered by the seller to the oil storage facility in Cushing, Oklahoma. So, the trick is not to get stuck holding a futures contract when it expires. However, cash-only contracts do not want possession of the oil. They want to speculate what the future price of oil is going to be in the future, so the system will settle their account if you don’t take any action to close it.
For example, if you are an investor and want to buy oil futures, you need to establish an account with a broker. Your broker is going to determine your “margins” on how you can use your account to buy oil futures. Margins are cash deposits that you must have in your accounts to participate in this market. Oil futures are bought and sold in 1,000-barrel increments. So, if you want to speculate on the price 90 days from now, you must deposit between 2 to 10 percent of what the contract is worth. A contract is worth $20,000 if the price of oil is $20, will require a deposit of $400 to $2,000 to play.
Sounds simple enough until speculators come into the picture and start to analyze weather conditions, political upheavals in the Middle East, pandemics, and pirates seizing ships in the Gulf of Aden, which is at the entrance to the Red Sea. Where is the Red Sea? Well, it lies between Saudi Arabia and Egypt and Sudan.
The uncertainty causes the prices for a barrel of oil to fluctuate. If you have a futures contract at $20 a barrel and someone offers you $25, you will most likely sell it and gain 5 dollars a barrel for a $5,000 gain (1,000-barrel x $5 gain = $5,000). And remember that you only put in anywhere from $400 to $2,000 in your margin account. So, you did great!
It could go the other way at lightning speed, so instead of selling at $25, it is now worth $15 a barrel. You have lost $5.000, and you must add money to your margin account to pay the difference.
Oil futures are not for everybody; however, if you have some spare cash and have studied how commodities are bought and sold, you can make money.