Opinion: Using the Futures Market to Control Oil Prices

This Opinion piece appears in the March 16  print edition of Transport Topics. Click here to subscribe today.

By Chuck Fulkerson

Instructor

Online Trading Academy

Living in Houston, a person gets accustomed to common topics of conversation. One very hot topic always seems to be the price of oil.

An overwhelming percentage of residents are involved in the energy industry, so the recent drop in oil prices has been

a shock for many families, who see their livelihood threatened. As a person who does not rely directly on the price of oil

for income and always is looking at things through the lens of trading and investing, I have a slightly different perspective.

Recently, I saw a commercial for a local furniture store that offered customers who purchased more than $7,000 worth of furniture the opportunity to take home that furniture for free if oil traded above $85 per barrel at the end of the year. Upon hearing this offer, one word came to mind: futures.

The futures market is a misunderstood and, often times, feared market. The current price of oil, falling below $50 a barrel for the first time in many years, has made an increasing number of people look to the futures market as an opportunity to lock in lower prices and hedge against cost increases.

For people not familiar with futures contracts, there are a few simple fundamentals that lay the foundation for understanding this asset class. A futures contract allows someone to control a product for a period of time without ever physically owning the product. For example, as of Jan. 21, 2015, the December 2015 oil-futures contract was trading at $53 a barrel. This means the buyer of a December 2015 oil-futures contract would be obligated to either buy 1,000 barrels of oil at $53 a barrel when the contract expires in December or sell the contract before its expiration date.

Because each contract controls 1,000 barrels of oil, the buyer of the contract is obligated to purchase $53,000 worth of oil, but the buyer does not have to front the money. In lieu of this, the contract holder can put down a “good-faith deposit” — typically 10% of the purchase price — which acts as a way to control the product without having to own it.

Why is this important? What does this have to do with the transportation industry? Everything.

Most members of the transportation industry put forth great effort to develop systems designed to operate their businesses at maximum efficiency, specifically controlling fuel usage. For instance, extensive tests are performed to ensure vehicles are aerodynamically designed and fuel-efficient, and delivery drivers are routed to consume the least amount of fuel possible.

No matter the size of the fleet, the best way to control fuel costs is to understand how to use futures contracts. For example, as the rising price of fuel will affect profits, the effect can be mitigated by hedging rising fuel costs with futures contracts. This does require basic knowledge of market timing, but it puts a purchasing manager in control of a company’s profits like never before. Since one contract controls 1,000 barrels of oil — even if the buyer never physically takes possession of them — those oil barrels will have an effect on the eventual price paid for the fuel.

For example, if a person or company predicts that fuel will rise between now and December, an oil-futures contract could be purchased with, approximately, a $5,000 good-faith deposit. If oil is trading at $73 a barrel in December, before the contract expires, the contract can be sold, and a profit can be taken. That means at $53 a barrel a $20-per-barrel profit can be realized. This strategy can directly offset the amount of money lost in operations due to rising fuel prices.

Futures contracts still follow the same principles that govern any market — supply and demand. Understanding the supply and demand equation in any market provides a significant advantage over someone who does not.

In the transportation industry, the use of the futures markets is a way fleets can gain an advantage over those who do not. Futures contracts have been used by large corporations and financial institutions for years. Smaller companies, in general, are not as well-versed in — or aware of — this hedging tool. Even worse, these companies may have been taught to fear the futures market.

There are enough resources and specialized education to train transportation company executives on the proper use of futures contracts.

This latest sharp decline in the price of oil should be a wake-up call to members of the transportation industry. After all, Starbucks uses futures contracts with coffee; Kellogg’s uses them with corn; and McDonald’s uses them with food. The transportation industry should use them with oil.

With regard to the furniture store in Houston, I would speculate that he went long on oil-futures contracts to act as a hedge against the money he would lose if he had to refund all those furniture purchases. This store owner is a savvy business person who has ensured a very low-risk financial position — and gifted locals with some pretty entertaining commercials.

Fulkerson specializes in the use of multiple-asset classes, such as futures, options and currencies. Online Trading Academy provides professional trader and investor education.