Trading Oil Futures
January 9th, 2007 by Justin
I’m going to get a bit technical here, so please pardon me.
However it’s well worth it if you’ve ever invested in an instrument related to the price of oil, or if you look to in the future. There are far too many ways to invest in oil, and some of them are not worth your trouble. I’ll try to clarify here, but feel free to submit comments if you need f
urther clarification.
Oil Futures
Oil futures have at certain times been one of the best ways to take long positions on oil, betting that its price will rise. In the past, the outer months of oil were priced below the near months. This is technically called backwardation. Assume, for example, that you want to invest in oil, and hold it for one year on January 1st. Also assume that futures are trading at these prices currently for each month of expiration:
February: $60.00
March: $59.50
April: $59.00
And so on….
Following January: $54.50
If you buy futures for next January, you may have to pay a bit extra because the contract is thinly traded, but as you can see, you’re buying oil for over $5/barrel less than the current price. Assuming the near-month futures contract doesn’t move at all over the course of the year, you make $5.50 per contract, over 10%. Not a bad trade.
Now, take the opposite (and current) scenario, and you will see why, at many times, buying oil futures is a loser’s game because the market is in contango: it costs more to buy future the further out you go in time.
Assume you want to buy and hold oil for one year, and prices are as follows:
February: $60
March: $61
etc.
Following January: $71
In this case, to hold for a year, you have to pay $11/barrel more than the nearest month! This amounts to a loss of over 20% if oil stays flat while you’re holding it. As you can see, to break even on this trade, oil has to rally by 20%. To make a profit, it has to keep moving in your favor after that 20% gain.
Other options like oil ETFs (exchange-traded funds) are subject to the same weakness, although it’s less obvious. USO, the oil ETF, will gradually decrease in value even if the price of oil is holding steady, to account for the contango that is occurring in oil futures?
If you’re confused, it’s understandable. However, it’s key that you understand why the state of near- versus outer-months of oil futures (and any other commodity for that matter) can and will have a dramatic effect on your investment if you choose to trade them. All it takes is to pull up a table of futures prices and have a look at whether outer months are trading much lower, or much higher, than the near month.
I suggest Futuresource.com for this. Here is a table of oil prices:
http://www.futuresource.com/quotes/quotes.jsp?s=CL
[…] If you read my article on trading oil futures, you know that trading oil can be very expensive if you’re on the wrong side of the trade in terms of the carry charge. Another option worth exploring is ETFs, short for exchange traded funds. For a general explanation of the term exchange traded fund, click here. […]
[…] In recent articles I’ve discussed the two primary options for trading the price of oil directly. One was oil futures, and the other the oil ETF (exchange traded fund, symbol USO). I recently became aware of another option, which is as close as a private investor can get to trading spot oil, to my knowledge. […]