Oil prices change more frequently than the weather, and this will not be changing anytime soon. Some of the reasons why this is the case are the subject of parts one and two in this trilogy on oil’s price volatility. As such, oil companies have to constantly adopt and implement new ways of doing business which ends up costing companies capital and time. To save money, and time firms will pay a premium to not have to worry about the price of oil changing on its product after sinking capital into finding and producing it. A futures contract is a primary instrument to hedge against uncertain volatility.
A futures contract is an agreement between two parties, a buyer and a seller, that is completed through the aid of a financial intermediary. The intermediary, typically played by a futures exchange, organizes two separate contracts which, at the end of the day, form a future agreement. The first is signed between the buyer and the intermediary, which legally obligates the intermediary to sell a barrel oil on a certain future date for a certain price to the buyer. The second is between the seller and the intermediary, which legally obligates the intermediary to buy oil from the seller in the future at the future price. Once in agreement, both the buyer and the seller posts a monetary deposit, usually a percentage of total deal value, with the intermediary. This is called margin.
Unlike a regular equity security, by which the only way to turn a paper gain into cash is by liquidating it, with a futures contract, money is physically transferred from one of the party’s margin accounts to the other on a daily basis based on how the expected future price fluctuates.
For example, a refiner and producer will agree upon a futures contract through a futures exchange for one barrel of oil at $50.00 one month from now. Both the refiner and producer deposit $35.00 into the exchange as the margin. Tomorrow the futures price for that month closes at $49.00. The producer is happy as its agreed upon price for delivery one month from when the contract was entered is worth more than new price of $49.00. The refiner in this situation would’ve gotten a better deal waiting an extra day. Once the day ends, the exchange reflects this change, $1 is taken from the refiners margin and added to the producers margin, so that the producers margin account now sits at $36.00 and the refiners is $34.00. This process continues until the contract reaches its expiry date. Take a situation where the spot price the day the contract expires is $49.00. The exchange buys crude oil at the spot price for $49.00 and sells it to the refiner for $50.00, fulfilling the contract between the exchange and refiner. The producer than sells his oil at the spot price, $49.00 and is credited a dollar by the exchange. It is important to note that a future can be settled in cash, without the commodity being delivered.
To producers of crude oil and the variety of firms which turn it into value added products, the advantages of using futures contracts are enormous. Many production decisions become risky under price uncertainty. Wintershall AG’s head of exploration and production was recently quoted as saying “basically, volatility is the word.” The ability to become a party in a futures contract allows for a significant reduction of risk. A producer could lock prices in on enough production to attract investment on a new well, a refiner can add a futures trading strategy to complement their inventory, making their production schedule more certain to maximize efficiency and reduce capital depreciation costs. All in all the use of futures enables a more efficient market.
The market has also stood to benefit nation States which depend on oil revenues. In the wake of low oil prices, Mexico for example, has smoothed its transition by hedging the country’s production.
States with nationalized oil companies, such as Mexico’s Pemex, have a unique relationship with their government, they are near one and the same. As such, countries like Mexico can hedge vast quantities of their future production on markets using their tax base, which amounts to hedging government revenue. A recent Bloomberg article highlighted the fact Mexico saved $6.4 Billion dollars last year using a hedging strategy against the downturn. While low prices are ultimately a negative for all nations which use capital to produce oil, the ability of a nation state to hedge their tax revenue not only saves money, but places investor confidence into the state, a key ingredient to keep interest rates low, and a government solvent. Such a strategy is impossible for governments who don’t have this relationship with their oil producing companies.
The current crude pricing system’s main critique is that vast swathes of price volatility can enter the market. To guard against volatility firms hedge risk with futures contracts. The trade itself is largely symbolic, contracts are usually settled in cash without any commodity actually directly being delivered. This is possible because firms keep margins at the exchange to preserve balance. Such moves boost investor confidence, so that investment in new projects becomes palatable. This enables the market to be more efficient, allowing an overall more productive society with less economic waste. Countries with nationalized oil companies can use a hedging strategy to save money, increase the predictability of their tax revenue, and keep investor confidence. As volatility continues to pervade oil and gas headlines, its worth understanding how it comes into existence and how entities overcome the challenges associated with it.