TRADING PLACES – inside the oil futures market

Karen Matusic

Nymex FactsBiggest commodities futures marketVolumes account for more than 10 times world oil production

Started as a milk and butter exchange in 1872First energy contract was in heating oil in 1978, Crude oil followed in 1984 and is today the most widely traded commodity contract in the world

More than $4 trillion/year traded, 200 million b/d of paper barrels traded on Nymex, IPEOpec role as price setter diminished as Nymexseen as benchmark for many physical and OTC contracts

Let’s get startedBig mouths welcome

Open outcry system (though computerized system ACCESS takes over at 4 pm to permit 22 hours of oil trade/daily)Trades completed in seconds – 1,000 contracts trade in every minuteHazardous job – blood drawn during Gulf War 1!

How a trade worksCustomer rings a licensed commodity broker with buy or sell orderBroker sends order to his floor trader via telephone or computerOrder slip is prepared, time stamped and given to floor brokers in the trading ring

In the RingOpen outcry is literally an auction

It’s a deal when highest bid and lowest offer meetBroker then enters transaction on a card which shows: commodity; quantity; delivery month; price and broker’s badge name and buyer’s name (Interesting badge names like Id, Ego, Boom, Loud, Talk and even Nose )Seller then throws the card into center of trading ring. Within one minute card is time stamped and sent to data entry room for keying into systems (and soon appears on screens) – 972 feet of paper is swept up on Nymexfloor every day!!Customers are then notified by originating brokers that the deal is complete

Nymex Facts

Covering your tracksWhile the CFTC and the exchange are aware of each party in any given transaction, the market is notSome big players use several brokers to keep the size of their dealings close to their chest

Removing risk from risky bizOnly commodity market regulated by Commodity Futures Trading CommissionMarket players protected in various ways

The Clearing House – Intermediary immediately after price in any deal is agreed (60-70 members – big banks and financial institutions)Margin – good faith deposits placed with clearersMarking to market (via daily resettlement that forces both sides to take profit or loss on a daily basis)Nymex only US futures market requiring commitment of trader data

Hedging ToolWhat are futures?

Legally binding obligation to buy or sell a particular commodity at specific price, location on specific future dateSame quality, quantity, delivery termsMost widely used for hedging (protection against fluctuating prices -- producers lock in prices to protect against price falls, refiners hedge against price rises)Hedgers are not out to get rich gambling on futures – aim is steady revenue, costsNot as many oil producers/users hedge as one would think (Exxon, airlines, Saudis)

Buy Low, Sell HighSpeculators look for profits

Unlike hedgers, they do not hold offsetting positions in the physical marketMost are not even interested in supply-demand fundamentals – computerized trend spottersPlay important role by adding liquidity -$18 billionCan be called “non-commercials” – large speculators holding multi-million dollar exposures

Funds not all the sameTypes of speculators

Day or independent traders “Jobbers”Plain vanilla funds (pension mutual)Hedge funds/Commodity pools – Heart of speculating community. Manage money for wealthy investors (George Soros, Paul Tudor Jones)

Hi Tech

When in doubt, blame technicalsUsing the past to predict the futureCharters graph price movements to determine trends – resistance/support/reversal, double-tops/double bottoms, head and shoulderHistorical volatility – based on time frame and price intervalMoving Average – (open, high, low, close, midpoint, average) to follow the trend signalRatio – determine overvalued and undervalued markets through price relationships

Still more technicalsRelative Strength Index – Study to measure markets’s strength, weakness and determine whether market is overbought or oversold

Stochastic Oscillator – Computer-generated overbought/oversold indicator

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Yet more technical aidsOpen interest/volume

Increasing volume considered indication that current price trend is strong, likely to continueOpen interest – the number of long or short positions in a contract that have not been offset. Considered indicative of market strength during period of rising prices or weakness during period of falling prices But if volumes are falling while prices are rising may be harbinger of price reversal

OptionsTwo types

Call – gives holder right but not obligation to buy the underlying futures at specific price up to given timePut – gives holder right but not obligation to sellBuy calls when you think prices will go up and puts when you foresee sideways to lower pricesTarget price is the exercise of strike price The buyer pays a premium, or the price of the option, to the seller for the right to hold the option at that strike

OptionsA wasting asset

Premium declines as time passesBuyer has three alternatives – exercise the option; liquidate it by selling or buying it back on the Exchange; or let it expire without valueWhy get involved? It allows hedgers to protect against adverse price moves while enjoying favorable price moves. Only cost is the premium. Less expensive than futures

Paper BarrelsAbout 95% of oil traded on the Nymex never shows up as physical product

Most hedgers close out positions before contracts expire, and then make or take their physical deliveries through people they usually buy or sell their actual supplies. Knowing that at any given time, however, someone may actually demand to buy your products, or sell theirs to you at that price, helps keep the value true to life.

Taking delivery

If a company decides to take delivery, there are some options:

Standard deliveryAlternative delivery proceduresExchange for Physicals (EFPs) – can choose trading partner, delivery site, product grade, timing. Price must be submitted to the Exchange and there is a nominal fee

CASE STUDY

The refinerHas to buy 3,000 b/d or 90,000 bbls/month to run the refineryWorries about crude price rises, especially in winterHedges purchases for high runs in December by buying crude futures to lock in Dec purchase prices – a LONG HEDGE

Case Study cont.

Step OneIn October, refiner buys 90 contracts (1,000 bbls = 1 Nymex futures contract for light sweet crude) for future delivery at average $19.50/bbl. The refiner is now NET LONG 90 contracts

Case Study cont.Step Two

In late November, refiner buys 90,000 bbls of crude from producer for $19.80/bbl to meet December demandAt the same time, refiner liquidates futures hedge or offsets the long position by selling futures. The refiner sells 90 contracts for average $19.80/bbl since prices did indeed rise as refiner anticipatedThe futures’ gain of 30 cts/bbl was applied to physical crude purchase costs – Result refiner paid $19.50/bbl not $19.80/bbl – savings of $27,000

Thank you for your attention.

Please feel free to ask any questions you might have at this time.