Futures are financial contracts. You have futures markets for all different types of commodities such as, corn, wheat, soybean, sugar, cocoa, natural gas, oil, and a whole host of other things. You can see the whole list here (Source : CME Group)
We call futures as financial derivatives because their value is derived from an underlying commodity. It could be a physical commodity such as corn or sugar, or, a financial instrument such as currency
Why buy futures ?
It’s essentially a way to hedge price risks. Say, you are in the business of buying lots of natural gas and selling it to customers. If a winter is particularly harsh, people demand a lot of natural gas for heating up their homes, and staying toasty. Given an increase in demand for heating, the price of natural gas increases as well
Futures help you hedge such price risks
Typically, natural gas is priced in units of, dollars per million Btu ($ per MMBtu). Imagine the price of natural gas to be $ 5/MMBtu today. Since your entire business depends on the margin between buying natural gas at a low price, and selling it to customers at a higher price, if the price of natural gas begins to increase disproportionately in the winter, then your margins become thinner. You certainly don’t want that
So, you’d buy natural gas futures today. This financial contract would let you buy natural gas (for example) on December 2nd 2024, at a price of $ 8/MMBtu, regardless of the spot (market) price of natural gas on 12/02
If the market price of natural gas on 12/02 is $ 10/MMBtu, then you only need to pay $ 8/MMBtu, and you gained $ 2. You need to pay a fee to buy a futures contract, hence you technically profit, $ 2 minus the fee
Speculators (such as you and me) can buy futures too, and we can take advantage of price movements to make a profit, but I’ll focus on businesses for the rest of this article
So, why are we talking about this ?
Last weekend was when Iran attacked Israel, and the word got out around Friday morning. Iran exports around 1.5 million barrels of oil per day, and it is this supply shortage that businesses are very nervous about (Source : FRED, Federal Reserve Economic Data)
If there is volatility in the Middle East, scarcity in crude oil supply from the region causes a significant increase in oil price (as we have learned from 1973 oil embargo and 1979 Iranian revolution)
So, businesses essentially feared such drastic increase in crude oil prices in the future, and they wanted to hedge such price risks by buying futures. Buying futures would lock in prices at which they can purchase oil, even if the market price of oil in the future is very high
Oil refineries are a great example, they buy crude oil and refine it to produce products such as gasoline, diesel and jet fuel. When volatile geopolitical events happen, they buy crude oil futures to lock in future prices, and hedge price risks
Until Wednesday this week
When you buy a lot of something, the price inevitably increases. Futures are no different. When you buy a lot of futures, the price of futures increases, which is exactly what you see between Friday and Sunday last week
Below is the Brent Crude Oil Futures price for the last 15 days (starting from this most recent Wednesday). The previous Friday to Sunday is when the war happened and the futures price reached a peak of $ 92.18 per barrel (Source : Thinkorswim, Charles Schwab)
As the initial fears of a back and forth between Iran and Israel subsided, price dropped. This is probably because the buyers of futures sold them back after realizing things are not going to escalate. Selling indeed decreases prices
In addition, businesses realized that things are not going to escalate, and there is probably not going to be supply shortages of oil from Iran in the future. Hence there is reduced demand for futures - this also decreases the price of futures
After all, why would you spend so much for buying oil futures, when the price of oil in three months is probably going to be lower
On Friday
Early morning Friday (just after midnight in New York) is when we began to realize Israel retaliated by attacking Isfahan, a city in central Iran. The attack was symbolic to display a show of strength. Businesses and investors reacted more forcefully, and you can see the monumental spike again, which once again receded, as things appeared to have settled down
Reading oil markets is a good tell-tale for what happens in the middle east
This is exactly what we expect profit maximizing firms to do, and it is exactly what they did