Major traded oils
More than 170 different oils are traded on the market, but this section will discuss the three major oils that usually attract the most attention, both in the news and in the markets around the world. West Texas Intermediate (WTI) is a crude oil of extremely high quality and because of this property, it is possible to extract more gasoline from a single barrel compared with most other crude oils traded on the market. The WTI has an API 10 gravity of 39.6 degrees, which gives the oil the characteristic of “light”; moreover the concentration of 0.24 percent of sulfur makes it a “sweet” crude oil. Those qualities together with the extraction location, make the WTI the prime crude oil refined within the United States, which is the largest gasoline consuming country on the planet. The vast amount of the WTI crude oil is refined mainly in the Gulf Coast and in the Midwest regions. Because of its characteristic, the WTI crude oil, is usually priced higher than the other two main traded oil: respectively $5-7 per barrel higher than the OPEC basket and $1-2 more than the “Brent Blend”.
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Read also Crude Oil Price
Brent Blend
we always hear about Brent Crude Oil Price and Brent Blend in the news, so let us first define Brent Blend:
is a combination of different types of crude oils, which are extracted from 15 fields throughout the Nynas system, located in the North Sea, and the Scottish Brent. The “API Gravity” of this particular oil is 38.3 degrees: this characteristic makes it a “light” oil similar to the WTI, but not as much as the WTI. In the same way, the quantity of sulfur contained (0.37 percent), makes it a “sweet” crude oil, but not as “sweet” as the WTI. Brent Blend properties make this crude oil excellent for the production of gasoline and middle distillates, which are most used in North-West Europe. As for the WTI, the production of the Brent is in a declining trend, but remains one of the major benchmarks to analyze the price of crude oils both in Europe and in Africa. Usually the Brent Crude Oil price is approximately $4/barrel higher than the OPEC Basket price and $1-2 lower than the WTI.
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OPEC Basket Oil price
This is a weighted average of prices for petroleum blends produced by OPEC countries. The basket is composed of 11 different types of crude oils from Algeria, Saudi Arabia, Nigeria, Venezuela, Ecuador, Iran, Iraq, Kuwait, Libya, Qatar, UAE and Angola. The acronym OPEC means “Organization of Petroleum-Exporting Countries” which is an organization that was created in 1960 to generate common policies for the production quotas and the sale prices among its members. Compared with the WTI and the Brent Blend, the OPEC oil contains a higher percentage of sulfur and therefore is not as “sweet” as these oils; moreover, the OPEC oil is not naturally “light” as the WTI or Brent. Because of these two reasons, the quantity of gasoline that is possible to extract from this oil is lower, thus the prices of OPEC oil are normally lower than the WTI or Brent.
Futures contracts
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Different from forward contracts, futures are traded on regulated exchange markets. In order to be traded on exchange, the contracts need to have standardized characteristics. Furthermore, because this mechanism does not allow the two parties to know each other, the exchange also provides a guarantee that the contract will be honored, acting as a clearing house. As already mentioned in the previous section, the largest exchange markets, on which the futures contracts are traded, are both the CME and CBOT. On these two exchanges and throughout markets all around the world, a very wide range of futures contracts with completely different underlying assets are traded. Examples of commodities, beside the above mentioned crude oil, are sugar, coffee, lumber, aluminum, gold, silver and copper. The financial asset category includes stocks, currencies, indices and treasury bonds.
Specification of a future contract
The exchange, when creating new futures contracts, has to specify exactly the nature and the details of the agreement between the parties. Determined characteristics have to be examined, which include the grade (quality), the size of the contract (the amount of the asset that will be delivered), the location where the delivery will take place, and the exact date on which the delivery will be made. In some situations alternative options for the delivery locations or for the grade of the asset are possible, and are indicated on the contract. As a common rule, the party who is trading a shortposition (the party that agreed to sell the asset in the future at a prearranged price) has the faculty to choose the alternative that he prefers. When the party who has the short position is ready to deliver and thus has made a decision among the alternatives, the party has to communicate its selection to the exchanges through the issue of a notice. The main specifications defined by an exchange are:
The Asset
When a futures contract regards the commodities market this determination of the grade is fundamental for the proceeding of the transaction: within the market there are a wide range of different qualities of any commodities, thus it is important that the exchange determines the minimum grade that is acceptable. As an example the New York Cotton Exchange has stipulated the grade of its orange juice future contract as: “US Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1, with factors of color and flavor each scoring 37 points or higher and 19 for defects, with a minimum score 94.
Another example by the random length lumber futures specified by the CME: “Each delivery unit shall consist of nominal 2 x4s of random lengths from 8 feet to 20 feet, gradestamped Construction and Standard, Standard and Better, or #1 and #2 however, in no case may the quantity of Standard grade or #2 exceed 50%. Each delivery unit shall be manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber-produced from grade-stamped Alpine fir, Englemann spruce, hem-fir, lodgepole pine, and/or spruce pine fir. For certain commodities there is also the possibility to deliver a range of grades of the asset, but, in this case, the price paid from the counterpart depends on the grades of the commodities chosen for the delivery. As an example, in the CBOT, the standard grade of a corn futures contract is the “Number 2 Yellow”, but substitutions are allowed, therefore the price has to be adjusted respecting the rules and procedures established by the exchange. Differently from the commodities, the financial assets that underlie the futures contracts are usually well defined and do not leave space for ambiguity. For example, it is not necessary to specify the grade of a currency. Although the futures contracts on the financial assets may always seem clear, there are some situations in which the determination of the prices become more complicated. In a Treasury bond the underlying asset is any US Treasury bond that has a maturity date longer than 15 years and that is not callable within 15 years. Because of the differing expiration of the T-bond from the futures contract on the same Treasury Bond, the exchanges have determined formulas that are utilized to adjust the price of the futures based on the coupon and maturity date of the bond delivered.
The Contract Size
The contract size determines the amount of the underlying asset that has to be delivered for a single contract. Finding the optimum amount for delivery is a key decision for each exchange. If the stabilized contract size is too large, then the traders who wanted to hedge small positions or make small speculation trades will not be able to operate on the exchange. On the other hand, having a too small contract size, will increase the overall cost of transaction, as the number of contracts that will be necessary to cover the same amount will rise. There is no a correct size of a contract, but it depends always on the user who takes part in the transaction. Whereas the values of some futures contracts are a few thousand dollars for some agricultural products, others can be much higher, such as the crude oil or more generally the financial futures that have a face values of over $100,000. In some exchanges, other types of contracts have been introduced in order to attract small investors. An example of those smaller contracts, called “mini”, is the E-Mini S&P500 Futures, which has a contract one-fifth the size of the regular S&P500 Futures.
Read Also Crude Oil Trading
Delivery Arrangements
The exchange has to determine the location where the delivery will take place. This specification is a factor of key importance for commodities that implicate significant transportation costs. For example, the CME specifies the delivery location of random-length lumber futures contracts as: “On track and shall either be unitized in double-door boxcars or, at no additional cost to the buyer, each unit shall be individually paper-wrapped and loaded on flatcars. Par delivery of hem-fir in California, Idaho, Montana, Nevada, Oregon, and Washington, and in the province of British Columbia.” If there is the possibility of alternative delivery locations, the price that the party selling the futures contracts receives will be adjusted according to the location chosen. For example, the corn futures contracts that are traded within the CBOT gives the possibility to the party with a short position to deliver the commodity in Chicago, Toledo, Burn Harbor or Saint Louis; although the commodity delivered is the same, but because of the price adjustment, the deliveries that are made in Toledo and Saint Louis will have a discount of $0.04 per bushel compared to the price traded in Chicago.
Delivery Months
Futures contracts based on the same underlying asset have different delivery months. The exchange has to determine the period (month) in which the operation of delivery can be executed. As a general rule on the futures contracts, the delivery can be made during the whole month. The delivery months are not fixed, but can vary on each contract. The delivery period and modality of the Light Sweet Crude Oil Futures at the CME/NYMEX is defined as:
(A) Delivery shall take place no earlier than the first calendar day of the delivery month and no later than the last calendar day of the delivery month.
(B) It is the short’s obligation to ensure that its crude oil receipts, including each specific foreign crude oil stream, if applicable, are available to begin flowing ratably in Cushing, Oklahoma by the first day of the delivery month, in accord with generally accepted pipeline scheduling practices.
(C) Transfer of title-The seller shall give the buyer pipeline ticket, any other quantitative certificates and all appropriate documents upon receipt of payment. The seller shall provide preliminary confirmation of title transfer at the time of delivery by telex or other appropriate form of documentation.
Although this chapter discusses about delivery methods and periods, most of the futures contracts do not lead to actual physical delivery. The traders usually decide to close their open positions before the expiration of the contract and thus before the delivery date. This operation can be done by entering into a trade with the opposite direction in respect to the original one. For example, a Chicago trader who sold a contract of crude oil on April 3, can close out his position by buying a contract (i.e. a long trade) of the same asset on May 3. In this case, the investor will register a profit or a loss depending of the difference of the futures prices between April 3 and May 3.
Price Quotes
The futures contract prices are created in a way that is convenient to understand them. For example, the crude oil futures price at the CME is quoted as two-decimal places of dollar per barrel. Therefore the minimum movement that the price can have is $0.0117. The Natural Gas futures contract listed at CME is still quoted in dollars, but given its different nature, it is listed at dollar per mmBtu (British Thermal Units) and the minimum price variation is $0.0001 for MMBtu18 .
Price Limits and Position Limits
For the vast majority of futures contracts, the limits of the daily price movement are specified by the exchange. If the price increases and hits the upper limit set by the regulations, the contract is “limit up.” On the other side, if the price of the contract drops to the lower level, it is said to be “limit down.” Usually, when the price hits either the upper or the lower limit, the transactions of the day for that futures contract ceases. In some particular cases, however, the exchange can decide to change the limits and therefore not to end the trading day. The main purpose of the price limit is to preclude large price movements, which may be generated by the trading operations of speculators. On the other hand, the price limit can become a barrier that can artificially contain the pace of the price movement of the futures contracts, while the underlying asset may be moving (increasing or decreasing) its price at a faster pace. An example of price limit regulation on the crude oil Futures at the CME: “Initial Price Fluctuation Limits for All Contract Months. At the commencement of each trading day, there shall be price fluctuation limits in effect for each contract month of this futures contract of $10.00 per barrel above or below the previous day’s settlement price for such contract month. If a market for any of the first three (3) contract months is bid or offered at the upper or lower price fluctuation limit, as applicable, on Globex it will be considered a Triggering Event which will halt trading for a five (5) minute period in all contract months of the CL futures contract. Position limits regulate the maximum amount of contracts that a single trader may hold. The main purpose of these limits is to avoid a single speculator excessively influencing the market.
References:
1. Technical analysis trading strategy – Masaryk University Faculty of Economics and Administration.
2. Oil Market Basics – Office of Oil and Gas, Energy Information Administration.
