Insight on the mechanism of future contracts in oil trading


Every investment engine has specific terms and parts that are peculiar to them. A future  contract is a term that is generally applied in economics. It is by definition a legally binding agreement between two willing parties to sell or buy a good or product at a specific date in the future and at a  predetermined price. In the world of oil trading, future contracts have a strict standard of quality and quantity. In essence, the buyers have agreed to abide by the future contract and purchase the oil at the specified date and price and the seller is also in unison to do the same. Future contracts are legally binding subsets of financial contracts which obligate the two agreeing parties to carry out the transaction in question at the specific time and date. The major reason why oil future contracts are used is for hedging or trade speculation. This helps trading parties to prepare for that future date specified as the quality and quantity that was initially agreed upon will be available. Future contracts are quite popular as people most throw the word ’future’ around when referencing oil trading. For example, people say they bought oil futures. This is essentially the same thing as a future contract, it is just a more informal version used among traders.

Future contracts are occasionally confused with forward contracts. However, there is a thin line that separates the two of them. Forward contracts have a striking resemblance to future contracts and follow the same principle to tying down a future transaction in the present. However, the difference between the two concepts is that forward contract transactions are carried out over the counter and the parties are able to alter the terms. In future contracts, the terms are preset and cannot be altered at any future time.

Future contracts are majorly used by two parties in the market. They are Hedgers and Speculators. In the market, producers or buyers of oil hedge or specify the price at which the oil will be sold or bought at a future date. On the other hand, investors and traders on platforms like are also trying to place bets on the movement of the prices of oil on the charts. They do this by using futures.  These two parties are what make up the entire oil trading community. The thing about future contracts in the oil industry is that they help the different participants of the industry stay afloat. For example, if an oil-producing company requires an immediate sale after completing the extraction process, they can easily lock it down with a future contract. Likewise, if a manufacturer company needs oil for its production process at a future day. Because the manufacturing company does not know what prices might be like on that future date, they can easily lock their needs in the present with a future contract. This risk reduction method applies to both parties. This is because oil is a highly volatile commodity, as such, its price fluctuations might be sometimes impossible to predict. This is why these companies require the use of future contracts.

Future oil contracts are kept in check by the use of a mathematical model which takes account of all the different factors which could affect the worth of the oil in a future date. These factors include; the present spot price, time frame till maturity, the risk-free rate of return, dividends, the different kinds of yield, and the storage cost. These give a clear view of what the future of these prices holds and how they might affect the current future contract being drafted.

There is no easy way out of avoiding risks in any investment; right from the traders, down to the participants in the actual oil production process, all of them run the risk of loss. This is what makes future contracts such an essential part of the oil business.

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