Most people don’t understand how futures markets work. Unfortunately, one needs to understand the basic mechanics of these markets to understand much of the news in recent weeks.
The Commodity Futures Trading Commission has launched an investigation into the possible illegal manipulation of oil futures. Congress is considering legislation to limit the ability of pension and hedge funds to put money into commodity futures. So a brief primer may be useful.
A futures contract is an agreement to buy or sell a commodity like corn or crude oil at some specified date in the future. The quantities are standardized, lots of 5,000 bushels of corn or 1,000 barrels of crude oil, for example.
If you contract to pay $6 per bushel and accept delivery of 5,000 bushels of corn this coming December you have “bought December corn.” And someone else who “sold December corn” agrees to accept $6 per bushel and deliver that amount.
(Few futures contracts actually result in delivery, however, even between a farmer who grows wheat and a flour mill. Instead, as the delivery month approaches, the farmer who contracted to sell wheat executes another contract to buy. The two contracts cancel each other out and the farmer sells his wheat for cash to his local elevator. The flour mill executes an offsetting contract to sell, and buys wheat on the cash market. Even though no delivery takes place, that does not mean, however, that the two parties were not using futures contracts to lock in a price. That’s another column, however.)
Futures markets are made up of exchanges — financial institutions through which such futures contracts are made and settled. Traditional exchanges have physical trading floors where traders, often dressed in outlandish garb so other traders can identify them quickly, enter into futures contracts for clients of their brokerage firm or for their own account as speculators. But increasingly futures exchanges are moving to computerized “screen” trading.
For anyone contracting to sell, there must be someone else willing to contract to buy at the same time, and vice versa. But once a contract is established, the buyer and seller have no further financial relationship. The clearinghouse of the exchange becomes the intermediary. If a seller fails to meet his contractual obligations, no individual buyer suffers, and vice versa. The clearinghouse handles the legal proceedings needed to clear up the mess.
The clearinghouse is protected in that buyers and sellers each must post “margin,” a financial deposit that guarantees their performance. If the price moves in a direction that is adverse for them, they are required to post additional margin to maintain a financial cushion that protects the exchange. If they fail to post additional margin when requested, the clearinghouse closes out their contract and they forfeit whatever amount of margin needed to cover the difference between the price they contracted at and the one at which their position was closed.
Take a contract for “light, sweet crude oil” on the New York Mercantile Exchange. The contract amount is 1,000 barrels or 42,000 gallons. The oil is priced in dollars per barrel and the minimum price change is 1 cent. That equals $10 on a 1,000 barrel contract. If the price moves $1, the value changes $1,000.
You contract to buy 1,000 barrels this December at $120 per barrel. That is $120,000 but you only have to deposit $10,000 right now. You will be asked for additional margin if adverse price moves reduce your margin below $8,000. (These are slightly rounded from the actual current margin for simplicity’s sake.)
What is an adverse price move for someone contracting to buy? By December you will need to make an offsetting contract to sell. If the price is above $120, you will have gained. If the price is below it, you will have lost money.
Suppose oil drops to $117. You would lose $3,000 if you closed out your position now. Your margin account is now $7,000 and you will have to deposit at least another $1,000 to meet your contractual requirement. If oil had risen to $125, your margin account would have risen to $15,000.
Note that if someone enters into futures contract to buy and the price keeps going up, the requirement to maintain margin is not a problem. This reportedly is the situation of pension funds and other institutional investors newly jumping on the commodity bandwagon. If you have contracted to sell and prices continue to rise, you get called for more and more margin. That is the situation for a lot of farmers.
As long as farmer-sellers can come up with the money to meet margin calls and as long as the price at their local elevator stays at predictable levels in relation to the price in Chicago, all can turn out well in the end. But that, and the plight of institutional investors in oil futures if price hikes reverse themselves, is the subject of another column.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.