Module 5 · Ownership, price and failure

Futures, hedging and paper barrels

Level 3 · Specialist 11 min read 4 questions

Far more oil is traded on paper than is produced. This lesson is what those contracts are for, who uses them and why, and what the volume figures do and do not mean.

Alongside the physical chain runs a financial one. A futures contract is a standardised agreement to buy or sell a defined quantity of a defined grade at a defined place and month, traded on an exchange that stands between the parties. The standardisation is what makes it tradeable by people who never intend to touch oil.

Who uses these contracts, and for what

Producers

Sell forward to lock in revenue and protect a capital programme or a debt covenant. A producer hedged at a fixed level keeps drilling when prices fall - which is part of why supply responds more slowly to price falls than intuition suggests.

Refiners

Hedge the spread rather than the level: buy crude futures and sell product futures, locking a crack spread, because the refinery's income is the difference and not either leg.

Airlines and shippers

Buy forward to stabilise a major input cost. Jet fuel is often hedged with a related contract plus a basis adjustment, because the jet contract itself may not be liquid enough.

Physical traders

Use paper to hedge the price risk on cargoes they own while keeping the location and timing risk they are paid to manage.

Financial participants

Take positions on price without physical exposure. They provide much of the liquidity that lets the hedgers transact at all, and they are also the group whose positioning shifts fastest.

Hedging removes upside as well as downside

This is the point most often lost. A producer who sells forward at a fixed price is protected if the market falls and gives up the gain if it rises. Hedging is not a bet that prices will fall; it is a decision to convert an uncertain revenue into a certain one, usually because certainty is what the balance sheet or the lender requires. Judging a hedge by whether it 'made money' against the eventual spot price misunderstands what it was bought for.

Paper volume is not physical volume

Traded volume in oil futures greatly exceeds physical production, and the ratio is not evidence of anything improper. A single physical cargo passing down a chain of intermediaries, each hedging and unwinding, generates multiples of its own volume in paper. Positions are also opened and closed many times before expiry - the overwhelming majority of contracts never go to delivery, because delivery is the mechanism that keeps the contract honest rather than the purpose of trading it.

Where paper and physical meet

Three mechanisms tie the two together, and all three matter when reading a dislocation.

1. Delivery. A contract that can be delivered against forces convergence at expiry: if the futures price and the physical price at the delivery point diverge, someone can profit by taking or making delivery.
2. Exchange for physical. A standard mechanism that lets counterparties swap a futures position for a physical one off-exchange, which is how a great deal of physical oil actually changes hands.
3. Storage. The carry trade from lesson 7 links the shape of the paper curve to the physical act of filling a tank.

When the delivery point is physically constrained - tanks full, pipelines committed - the third mechanism stops working, and the futures price can move to a level that makes no sense as a price for oil in general. It is still a perfectly sensible price for oil *at that point on that day*, which is all the contract ever promised.