What Are Oil Derivatives?

Oil derivatives are financial instruments using oil, usually crude, as an underlying asset. The derivative has no inherent value and is only a contract for an oil-related activity, but people can trade, sell, and buy derivatives to access the value of the oil used as the basis of the contract. Such contracts have been a part of financial markets since the 1800s and provide producers of various products with a number of useful tools for conducting business. Companies can use oil derivatives to distribute and reduce risk, as well as to address issues like not wanting to store oil for extended periods of time.

The most basic oil derivative is a futures contract. When people prepare the contract, one party agrees to buy a set amount of oil at a given price on a date in the future. Another form is an options contract, where people have the option to make a purchase on a particular date, and they can then decide whether they want to exercise it. Oil derivatives allow people to manage risk; for example, a futures contract can help people avoid temporary volatility in oil pricing and get oil at a guaranteed price. Options can provide for hedging, creating an opportunity to buy below market price or sell above it, depending on the structure of the contract.

While oil derivatives were initially developed for use by the oil industry, other investors can trade them. In many cases, people trading derivatives have no plans for taking delivery of the underlying asset; a Wall Street investor has absolutely no interest in a tanker ship worth of oil, but does want to take advantage of shifts in oil prices to profit on oil derivatives. These contracts provide a mechanism for investing in commodities trading. People can also buy and sell stocks and bonds issued by oil companies.

Trading oil derivatives requires knowledge of the industry, skill, and the ability to make savvy market projections. People rely on numerous kinds of data to make investment decisions. The news can provide insights into potential future changes in oil prices, and people also pay attention to political developments, oil policy, and issues like consumer demand. Knowing, for example, that demand for oil tends to rise in the summer, people can plan their investment activities accordingly.

Derivatives trading is usually the purview of advanced investors or special funds. It can be risky, especially in large volumes and on a volatile market. Even skilled investors may make mistakes when it comes to predicting future financial moves, and this can translate into costly losses.

How Do Oil Derivatives Work?

Oil derivatives describe financial instruments, typically contracts, that involve oil. People can buy, sell, or trade oil derivatives as they would in other financial contracts. Oil derivatives are a subtype of energy derivatives that include electricity and natural gas in addition to oil. Due to the inherent difficulty of predicting changes in market value, they are an advanced and risky form of trading generally only pursued by companies, special funds, or expert investors.

Having existed since the 1800s, oil derivatives were initially created to be used exclusively by the oil industry, but they have since opened up to outside investors. While oil derivatives have no intrinsic value and investors are uninterested in the actual oil they purchase, they can be used to facilitate commodities trading. In theory, those with oil derivatives would be required to take ownership of the oil they purchase if the contract reaches its expiration date. In practice, derivatives are traded long before their contracts expire, so it would generally not be necessary for the derivatives trader to obtain the actual oil they purchased.

Unlike individual investors or firms, if a company is involved in oil derivatives, they may be after the oil itself if they can use it. This allows the company to avoid sudden shifts in market value so their production costs do not increase.

An example of an oil derivative is a futures contract, which means the person agrees to buy a set amount of oil for a specific price at a certain time in the future. The purpose of this contract is to avoid the inherent volatility of the oil market by guaranteeing a fixed price on a purchase. Thus, even if the value of the oil changes by the time the purchase is scheduled, the oil must be sold at the agreed price. The second type of oil derivative is an options contract which gives the person the option to purchase oil on an agreed-upon date. This allows the purchaser of the contract to buy or sell oil at the market price on that date. This allows the investment to be hedged. Different contracts may have unique terms that are flexible, but these are the basic types of oil derivatives.

Predicting the value of oil derivatives generally comes down to following data and news that may affect the market value of oil. Consumer demand, oil policy, and political developments are all capable of changing the price, to name a few types of information oil derivative investors follow.

What Is Involved in Oil Derivatives Trading?

There are two main types of trading: formal commodity exchanges and over-the-counter trades.

Oil derivatives, like other energy derivatives, can be traded formally on a market such as the Chicago Mercantile Exchange or New York Mercantile Exchange. Alternately, they can be traded through a broker-dealer network, which is often referred to as over-the-counter trading and is frequently used when the contracts do not meet the requirements necessary to be listed on a formal exchange market.

If you are using a formal market, you would first create an order. This order goes through the central clearinghouse which will match you with a buyer or seller automatically. Most of this system is automated which allows for large volumes of transactions to be traded rapidly and efficiently.

An over-the-counter trade is different in that it goes through either a financial intermediary or is pursued directly with a counterparty. Over-the-counter trades tend to be riskier than formal exchanges because of something called counterparty risk which is the chance that a party involved in the transaction may default on its contract. This risk is quantified by the credit score of the lender or creditor. If one party in the exchange has a higher counterparty risk than the other, they will often attach a premium, called a risk premium, to the transaction as a means of compensation. If the borrower in a transaction has a low credit score, the creditor will often charge higher interest rates or large premiums.

Parties trading oil derivatives regularly carry incentives like these if their credit rating is low. What this means in practice is that counterparties with low credit ratings are high risk but also high reward, whereas those with high credit ratings are lower risk and carry a lower reward.

The over-the-counter marketplace is typically used as an alternative for smaller companies that do not yet meet the requirements to be listed on a formal stock exchange. Due to the complications involved in over-the-counter trades, they are generally not used for large volumes of transactions, which are typically done in a formal market exchange.