A (Very) Short Introduction to Oil Futures

Oil futures contracts are legally binding agreements that obligate the parties involved to buy or sell crude oil at a predetermined price on a specific future date. By locking in the price at the start of the contract, oil futures help manage price volatility and enable speculation on energy market movements. These contracts are traded on regulated exchanges like NYMEX for WTI futures and ICE for Brent Crude futures.

Exchanges such as NYMEX and ICE act as intermediaries, matching buyers and sellers and clearing trades. They assume counterparty risk on behalf of market participants by serving as the buyer for every seller and the seller for every buyer. This process of replacing the original contract between the buyer and seller with new contracts between each party and the exchange is called "novation."

Oil futures contracts are valued at the time of sale, and then periodically revalued to reflect the current market price. For instance, if Alice buys a contract for 1,000 barrels of oil at $70 per barrel, the contract is worth $70,000. However, its value is adjusted daily based on the current oil price. If the price rises to $75, the contract's value becomes $75,000.

Long and short positions are formed by buying and selling oil futures, respectively. In the example, Alice is the long trader (buyer), and Bob is the short trader (seller). A long position gains when the settlement price exceeds the locked-in price, while a short position gains when the settlement price falls below the locked-in price. Profits and losses are settled daily using each trader's margin balance, a form of collateral deposited beforehand.

If a trader experiences losses, the amount is deducted from their margin balance, and the corresponding amount is added to the other trader's balance. The initial margin, usually 5% of the contract's total value, is the upfront deposit required, while the maintenance margin is the minimum balance needed to keep the position open, typically set slightly lower than the initial margin.

If a trader's balance falls below the maintenance margin, they receive a margin call, requiring them to deposit more funds to meet the requirement.

If a trader fails to meet a margin call, the exchange liquidates the position by closing it out through an offsetting trade, using the trader's remaining margin to collateralize the replacement position. This mechanism ensures that the exchange ideally maintains zero net financial obligations, as long as every long position is matched by a corresponding short position, allowing losses on one side to be covered by gains on the other without the exchange needing to use its own funds.