Understanding the Discrepancies Between Oil Futures Contracts and Spot Prices
The term 'oil futures contract' often conjures the image of a straightforward agreement where the price of oil is locked in for future delivery. However, the relationship between oil futures contracts and spot prices is more nuanced and can vary significantly. This article delves into the intricacies of how oil futures contracts are priced and their relationship with the spot market.
Understanding Oil Futures Contracts and Delivery
The term 'oil futures contract' refers to a standardized agreement in which two parties agree to buy or sell a specific quantity and quality of crude oil at a predetermined price and on a future date. Traditionally, a futures contract represents a volume of 1,000 barrels of oil (1 bbl) for most major exchanges, though specifics can vary by contract.
Contracts for future delivery of 1,000 barrels of oil are traded up until about 10 days before the delivery month begins. For example, the May 2020 contract closed its trading period on April 21, with the 'front month' being June 2020. This means that around 10 days before the delivery month, the contracts for that month are no longer traded on the exchange.
Contract Pricing and Average Values
The price of oil futures contracts is not fixed at the moment of trade. Instead, it is based on the average price over the trading days within the delivery month. For instance, if the May 2020 contract was averaging around $22 per barrel for 13 trading days, but then fell sharply to $-37 per barrel on the final two days as the contract expired, the overall average could still be around $18 per barrel.
Factors Influencing Final Oil Prices
When a producing company arranges sales based on the futures contracts, the final price the producer receives may be influenced by several factors beyond the straight prospects of the futures contract:
Roll Futures Adjustments: In April, there is often a roll adjustment, which is a fudge factor used to offset the difference between futures prices and the current spot prices. This adjustment can vary substantially; in April 2020, the roll adjustment was several dollars negative. This helps to bridge the gap between the nominal futures price and the actual spot price the producer receives.
Quality Adjustments: The oil's quality can significantly impact the final selling price. For instance, if the marketed oil is Louisiana Light Sweet (LLS), but the traded benchmark is West Texas Intermediate (WTI) at Cushing, Oklahoma, LLS might have a premium over WTI. These adjustments ensure that the actual delivery reflects the expected commodity's quality.
Taxation: In states like Louisiana, there are severance taxes on oil. Ignoring Louisiana’s 12.5% severance tax for simplicity, the price of a barrel will naturally be adjusted to reflect this tax burden.
Practical Examples and Financial Considerations
For a practical example, assume that a producer has an arrangement to sell 200 barrels each on the 5th, 10th, 15th, 20th, and 25th of a month. If the overall average price during these days is around $14 per barrel, the producer would receive a total of $14,000 for 1,000 barrels. However, the $37 price on the 20th is factored into this average, even though the producer didn't have to pay $7,400 on that day.
The Role of Margin and Contract Termination
Oil futures contracts are entered into with zero or near-zero value. Both parties post margin to guarantee performance, but they are not purchasing the commodity at that time. Payment of the futures price and delivery of the oil only happen at the termination of the contract. The majority of futures contracts are exited before delivery, reducing the need for physical delivery.
In conclusion, while the price of one oil futures contract may initially appear to be tied directly to the spot price, several factors influence the final price received by producers. Understanding these nuances is essential for anyone involved in the oil trading market, ensuring clarity and accurate financial planning.