Energy commodities—crude oil, natural gas, heating oil and gasoline—are bought and sold globally through Futures contracts (“Futures”). These are legally binding agreements for the physical delivery of a specified volume of a commodity at a specified time and place for an agreed upon price. Futures are not derivatives; they are contracts to actually purchase and sell the physical commodity.
Energy Futures are the most actively traded commodity contracts in the world. These contracts are priced in an auction process on the New York Mercantile Exchange (“NYMEX”), where crude oil and natural gas Futures can be bought and sold for various months over the next 10 years.
A forward price curve (“forward curve”) is the graphical representation of various prices for delivery of a commodity at different points in time.
There is no preordained shape to a forward curve. The underlying shape is determined by market expectations of future supply and demand. These expectations shift over time, sometimes quickly and quite dramatically based on new information about how political events, general economic factors and even weather will potentially impact supply and demand.
Forward curves tend to take three basic shapes:
- Backwardated – a “Backwardated Curve” is downward sloping. The current price is highest and prices decline over time. A Backwardated Curve is indicative of a market where current inventories are tight, but future supply is expected to catch-up with demand over time, causing expected future prices to fall. This is typically the normal shape of a commodity futures curve.
- Contango – a “Contango Curve” is upward sloping. The current price is lowest and prices increase over time. A Contango Curve is indicative of a market where current inventories are in a surplus condition, but expectations of economic growth or geopolitical events, which could disrupt the supply chain, cause future prices to be higher than current prices.
- Flat – a “Flat Curve” is one where the current price and prices into the future are the same. Flat curves for crude oil and natural gas seldom occur, as this condition tends to happen during a period where market expectations are radically shifting given a political event or there is a general shift in perceptions of global economic growth.
It is important to note that forward markets have historically proven to be poor predictors of actual realized prices at the time of physical delivery. Expectations at a given point in time set the pricing for Futures contracts. But expectations can change—and change quickly. For example, several years ago the 2014 forward price for natural gas was $8/mcf increasing to over $10/mcf in the future. Subsequently, new drilling technology created an opportunity for development of various shale basins, particularly the Marcellus, generating an abundance of cheap natural gas priced in the $3.50 to $4.50/mcf range.
Five States and the Forward Curve
Five States owns long-lived producing oil and gas properties. In trading terminology, we would say Five States is “long” physical oil and gas for some time into the future. Because these producing assets have predictable monthly production volumes, Five States can “lock in” the prices it will receive on future production at the prices available on the forward curve.
Five States hedges to reduce risk. Being able to sell forward, or “short” oil and gas futures at forward prices, allows Five States to lock-in future prices—securing cash flows and returns for our investors.
This type of hedging, based upon our expected physical production, is the opposite of speculating. It actually gives us an opportunity to reduce risk by reducing volatility. An example of this type of hedging transaction is shown below:
Assume the following pricing for 1 Futures Contract (1,000 barrels of crude oil):
- Hedge “today”: Five States (a Producer) sells 1 Futures Contract, or 1,000 barrels, for delivery in April 2015 on the New York Mercantile Exchange (“NYMEX”). A buyer of the Futures contract has agreed to purchase 1 Futures Contract in April for $90/barrel.
- Hedge Settlement: In April 2015, Five States, the seller of the Futures Contract, and the buyer of the Futures contract make a cash settlement based upon the final NYMEX price of the April Contract. In this example, Five States will collect the difference between $90/barrel and the current market price of the April Futures Settlement price of $75/barrel, i.e., Five States collects $15/barrel, or $15,000 in total ($15/barrel multiplied by 1,000 barrels per Contract), less transaction costs.
- Physical Sale: Five States sells 1,000 barrels of production in our regular sales channel for the market price on Settlement day for $75/barrel, collecting a total of $75,000.
- Hedge Settlement and Physical Sale Combined: The net of the hedge settlement for Five States, a gain of $15/barrel or $15,000 in total funds, combined with the sale of physical barrels at $75/barrel or $75,000, creates a net effective sale of 1,000 barrels at $90/barrel ($15/barrel gain from the Futures Contract plus the physical barrels sold for $75/barrel). This generates a net cash flow to Five States of $90,000 at the April Settlement of the Futures Contract and physical barrels.
Excluding basis risk for location or grade differentials, regardless of the actual price at which physical barrels are sold when the hedge is exited, the net price to Five States will be the same as the price at which the Futures were sold. In the example above, if market prices in April of 2015 had increased to $110, there would have been a loss on the futures contract and the physical barrels would have been sold for $110, but the net to Five States would still have been the same $90/barrel as in the previous example.
Many firms employ hedging strategies which use options in addition to buying and selling futures. Options on physical contracts are derivatives, as the economic transaction is derived from a relationship to an underlying physical transaction (in the case of Futures contracts).
Five States can and will employ some options strategies as appropriate. In a broader market view of using options as a hedging tool, the sale of options can act as an accelerant which exaggerates a market move.