Introduction to Trading in Oil Futures

It’s hard to understate how important petroleum is to even the least advanced of modern economies. No substance offers more energy per unit of extraction cost. Abundant and proven, oil will most likely remain the most popular energy source on Earth for some time into the future.

With the International Energy Agency projecting 2020 total consumption at 91.9 million barrels a day, oil trades in a sophisticated market with many tools and vehicles for investing or speculating in oil.

One way to speculate on oil prices is through trading in oil futures. 

How Do Oil Futures Contracts Work?

Oil futures contracts are simple in theory. They continue the time-honored practice of certain participants in the market selling risk to others who gladly buy it in the hopes of making money. To wit, buyers and sellers establish a price that oil (or soybeans, or gold) will trade at not today, but on some coming date. While no one knows what price oil will be trading at nine months from now, players in the futures market believe they can.

For example, suppose that Commodity X, which currently sells at $30, will be available for $35 in a contract dated to come due next January. A speculator who thinks that the price will, in actuality, shoot past that, say to $45, by said time can thus purchase the $35 contract. If their prediction is correct, they can then buy X at $35 and immediately sell it for a $10 profit. But should X end up falling short of $35, their contract is worthless.

Again, for some investors that futures contract is a way to get a guaranteed price of $35 down the road; for them, better one in the hand than two in the bush, even if X falls to zero. People on the opposite side of the transaction subscribe to another axiom: nothing ventured, nothing gained. If X shoots to $100 or even $200, the speculator who gambled on X settling at $35 will make several times his investment. The price the commodity in question is expected to sell for on the subsequent date is self-evidently called the "futures" price, and it can differ greatly from today's price. 

Unlike those for most agricultural commodities, futures for oil settle monthly. Other futures contracts may settle only four times a year, for example. The added frequency and regularity of oil contracts make it easier for investors to determine trends, or expected trends, in the eventual price of oil.

In September 2020, oil was trading at about $40 a barrel—more than $100 less than oil prices at their highest. In December 2019, oil was trading at approximately $60 a barrel. Demand in some regions of the world has recovered, although predictions for demand is 2021 have been adjusted to account for aviation sector weakness. The global demand for oil in 2021 is estimated to be 97.1 million barrels per day. Worldwide, product inventory levels remain very high.

At the same time, increased drilling in the United States has diminished the importance of threats and maneuvering of foreign cartels. Knowing that, what’s a futures investor to do? Assume that prices will continue to fall in the short term, or reason that we’re nearing the point where prices are approaching production costs and thus there’s nowhere to go but up?

Can You Predict the Future Through Futures?

In October 2020, the next month’s futures contracts—November 2020—are selling for $40.25 The following month’s—December 2020— is at $40.53; January 2021 is $40.88; February 2021 is $40.22; and at some point, two years from now, oil prices (or at least, oil prices as predicted by the level of futures contracts) are predicted to hit $43.46 a barrel. Nor does the rise stop there. Beyond the two-year mark, oil futures settle less semiannually or even annually, rather than monthly. The latest available contract, for 2031, sells for $50.34.

Two things: number one, predicting market movements more than 10 years hence is like predicting the weather or the outcome of the Super Bowl that far in advance. The New England Patriots might be in contention in 2031, or they could just as easily go 1-15: the vast majority of the players on that team are unknown quantities, currently playing in college or even high school.

The world of 2031 won’t bear a close enough resemblance to the present day to warrant predictions. Yet the oil futures market for 2031 exists, even though history shows that predicting prices that far out is a dangerous game.

Only Hindsight Is 20/20

To see just how dangerous, let’s see what the futures market of September of 2010 thought oil prices would be in 2015. During that month, December 2015 oil futures were trading for $89. And why not? $89 represented a level close to the then-current $76 a barrel oil was trading at, along with a premium of a few dollars to anticipate the continuation of a rising trend. This makes perfect sense. Except no one, or at least not enough people to make an impact, was predicting that increased production would drive the price of oil down to the levels witnessed in 2015.

Of course, if enough people could have foreseen that, the futures price never would have hit anywhere near $89 in the first place. There are infinite variables that determine the eventual price of oil, but our brains are capable of weighing only the most obvious ones, such as oil’s current price. We can look a month or two in advance with some accuracy, but it’s a straight-up roulette spin to try to figure out what oil will do once four more Olympiads and another presidential election or two have come and gone.

The market offers few guarantees, but here’s one that even Investopedia’s notoriously circumspect legal advisors will stand behind: The actual price of oil will be far more volatile than the relatively tight band of prices indicated by the trends in upcoming futures contracts. A gradual rise to $50.67, with a floor of $45? Don’t bet on it. How can we be so sure?

For one thing, the futures trend goes in only one direction. Every change, no matter how incremental, is a positive one. Sure, oil might consistently rise in price over the next eight years with no drops whatsoever, but it’s never done so in any previous stretch of that length and common sense dictates that it wouldn’t have.

The Bottom Line

To trade in oil futures, you need two characteristics that are often disparate: patience and boldness. You also need a large bankroll to get started. Oil futures contracts aren’t measured in barrels, but rather in thousands of barrels. That December of 2031 future will set you back $50,670, but in return will give you a liquid asset whose value will doubtless fluctuate between now and when it matures. That means plenty of time to potentially realize a profit, or to wait and wonder if you made a foolish decision. Either way, oil futures trading is not for dilettantes.