Energy Futures Contracts

Despite its relatively short history, the energy futures contract has become an essential part of the modern financial system, thanks to its efficiency in controlling volatility in the price of underlying commodities, including crude oil and natural gas. It is an effective hedging and diversification instrument helpful as an extra risk management tool for traders, investors and end-users. Energy futures contracts are one of the most liquid and broadly-traded markets globally. 

The market is well-developed, diverse and highly lucrative. It is also accessible to all types of market participants, including long-term investors, short-term traders, speculators and hedgers. As the global population surges, energy demand is poised to skyrocket. The implication is that the energy futures market is positioned to grow further. And so, it presents an excellent opportunity for smart investors or traders to reap returns. 

However, before investing in energy futures contracts, you’ll need to have a comprehensive idea of the steps involved in investing or trading the market, the benefits and risks involved and how the market generally works. This article covers the nitty-gritty of energy futures contracts in a way that'll make your investing journey a breeze.  

What is an Energy Futures Contract?

An energy futures contract (energy futures) is a derivative contract between two parties to buy and sell energy products or commodities at a predetermined date and price. Derivatives are financial instruments whose values come from underlying assets. The underlying assets for energy futures are energy products like crude oils, natural gas and electricity. As an investor, energy futures allow you to speculate or effectively hedge against fluctuating prices and other macroeconomic conditions that may impact energy products or commodities. 

For instance, if you've significant oil and gas stocks in your portfolio, you can hedge your exposure by buying energy derivatives whose value would increase as the stocks of such commodities decline. An investment firm with an extensive portfolio of oil and gas stocks can take similar approaches. Besides retail and institutional investors, energy producers and primary consumers also use energy futures contracts to hedge by fixing or locking in the price. 

For example, consider a hypothetical natural gas producer, "GasCo," looking to hedge 10,000 million British thermal units (MMBtu) of its February production. To achieve this, GasCo could sell one New York Mercantile Exchange (NYMEX) natural gas futures contract. Suppose GasCo sold the contract at a prevailing price of $3.822 per MMBtu at market closing. In that case, the company would've hedged 10,000 MMBtu of its February production at $3.822 per MMBtu. Since GasCo wouldn't like to make delivery of the futures, it would buy back one February futures contract on or before the expiration date of the initial agreement.

If the prevailing market price at buyback is $4 per MMBtu, GasCo would incur a hedging loss of $0.172 per MMBtu and receive $4 per MMBtu for its physical natural gas (excluding basis differential, gathering and transportation). If the prevailing market price at buyback is $3 per MMBtu, GasCo would incur a hedging gain of $0.822 per MMBtu and receive $3 per MMBtu for its physical natural gas (excluding basis differential, gathering and transportation). The gross profit in both cases remains $3.822 per MMBtu. Similar hedging approaches apply to all oil and gas producers. 

A similar but opposite approach is applicable to energy end users who may need to hedge their exposure to potentially higher energy prices. However, instead of selling the energy futures like the producer, the consumer or end-user would buy the energy futures contracts. Generally, while you may need to iron out a few details before buying or selling futures contracts, the mechanism is straightforward. To hedge your exposure against potential higher prices, buy energy futures contracts. When energy prices are declining, sell energy futures contracts as a hedge.

Types of Energy Futures Contracts 

Suppose you're going to start investing or trading energy futures. In that case, it makes sense to understand the core commodities that form the bulk of the market. The most developed commodities traded in the energy futures markets are crude oil, natural gas, gasoline and coal. Exceptions include ethanol and some electricity generation. 

Crude Oil

Crude oil is a naturally occurring unrefined petroleum mainly composed of hydrocarbon deposits. Crude oil and its derivatives, like crude oil CFD, are the most significant and actively traded commodity in the global financial market. It interacts with various sectors of the global economy as consumer goods and raw materials for production and transportation. 

Crude oil can be refined into gasoline and diesel fuels and is a crucial component of plastics, synthetic textiles, computers, cosmetics and fertilizers. Its diverse applications and presence in many aspects of everyday life make it highly valuable and benefit the price. Crude oil differs by type based on specific salient characteristics, including density or gravity, the field of origin and sulfur content.

The two global benchmarks are West Texas Intermediate (WTI) and Brent crude. Both are light (low density) and sweet (low sulfur content) crude oil. These characteristically make them easy to refine. WTI is the most widely traded commodity globally, being lighter and sweeter. The price of crude oil positively correlates with global economic growth. Economic expansion drives up demand, which also drives up the price increase. 

Natural Gas

Natural gas is a fossil fuel primarily used in electric power generation. It is also helpful for heating and refrigeration in industrial, commercial and residential settings. Demand surges over the winter and summer when heating and cooling increase. 

It is the cleanest burning fuel, producing fewer emissions than oil, and will likely outlast crude oil as the global community transitions to renewable sources. Natural gas is evaluated based on characteristics like volume and heating quality. It is one of the top three physical commodity futures contracts by volume and among the top 10 most actively traded on Chicago Mercantile Exchange (CME), the leading global future exchange.

Natural gas is considered chiefly a domestic commodity in the U.S. market, which makes sense because it is an important domestic energy source, and the U.S. is the global leader in production, followed by Russia. The national benchmark is the Henry Hub Natural Gas futures contract (NG) available on the NYMEX.

Gasoline or RBOB

Gasoline is traded in the commodity market as Reformulated Blendstock for Oxygenate Blending (RBOB). It is considered the most essential refined byproduct of crude oil because of its usefulness as fuel in various automobiles, including cars, motorcycles, recreational vehicles, electricity generators, small boats and aircraft.

Its prices correlate positively with those of crude oil. It is also up there among the top-traded energy futures contracts. RBOB products provide investors with an excellent means of expressing views on crude oil, consumer behavior, weather and regulations regarding current and future energy consumption from the investor's standpoint. The most popular RBOB future is RB.

Coal 

Historically, coal has been used as a primary energy source for power generation and steel production, among other applications. As energy needs rose during the Industrial Revolution, its use increased. Today, it still generates a significant amount of global energy supply and plays an essential role in diverse industries. 

However, as the fossil fuel era nears its end and emphasis shifts to renewable energy, coal usage is bound to be phased out, especially considering it offers limited alternative use, unlike crude oil. This trend is apparent even within the trade volume of the most popular coal futures, as the commodity significantly lags behind others in trading volume. 

Biofuels — Ethanol

The global pursuit of alternatives or eco-friendly energy sources makes biofuel an excellent investment opportunity for future traders or investors. The underlying commodity is ethanol — a clear, colorless alcohol produced primarily from grains or sugar. Ethanol is considered renewable energy since it is formed from biomass — organic materials derived from animals and plants. 

When blended with gasoline or diesel fuels, it produces a cleaner burning fuel with lower carbon monoxide and higher octane numbers. Although whether biofuels can be considered green is debatable, it offers a better alternative to traditional gasoline because it doesn't cause smog pollution and produces lower warming gasses — CO2, hydrocarbons and nitrogen oxides. So while this fuel type may not be the number one green energy source, it'll receive some consideration.

Electricity 

Electricity results from reactions that cause the flow of power or electrical charges. It is one of the most prolific energy forms with varying applications in the household, commercial, industrial and transportation sectors. Over the last several decades, electricity usage has dramatically increased globally, driven by the increased human population. In the U.S. alone, electricity usage is 13 times greater than in 1950. It is poised to skyrocket further as the population continues to expand. 

Its diverse use makes electricity futures contracts an excellent instrument for hedging. Emerging market demands, advances in alternative sources and portfolio diversification are other reasons you might consider electricity futures contracts. Specific economic, political and regulatory considerations may influence electricity trading. A lucrative trade may occur mainly in areas with high population and industrial growth.

How to Invest in Energy Futures Contracts

Investing or trading energy futures can be challenging, even for professional or experienced investors. However, when you follow well-laid-out steps, it can be as hassle-free as any other investing endeavor. Here's a step-by-step guide to kick-starting your energy futures investing journey. 

Recognize and Plan for Risk

Futures are leveraged investments, meaning you can control huge contracts with little capital. While leverage makes for efficient use of money, losses, when they occur, can be substantial. To protect your investments:

1. Plan carefully before establishing a position in the market.
2. Define your entry and exit strategy and risk management rules.
3. Decide whether you will use technical or fundamental analysis for your trading plan, or both. 

Select a Brokerage Platform 

The NYMEX is the most popular exchange for energy futures. It is a subsidiary of the CME but focuses primarily on energy commodities trading. Here you can trade four of the six primary energy futures contracts in the global commodity market. These include WTI crude oil, Henry Hub natural gas, gasoline and ultra-low sulfur diesel. The remaining two (Brent crude oil and gas oil) are available on another platform, the intercontinental exchange (ICE). Tokyo TOCOM is also an excellent choice. 

Besides this highly regulated platform, you can trade or invest in energy futures through most brokerages, just like stocks. Energy futures are highly liquid and so supported by most financial service providers. Ideal brokerages for energy futures should offer a highly intuitive trading platform, multiple order types to facilitate risk management, an abundance of charting styles and screening tools, real-time data and quotes and a wealth of research resources. 

Others include API to facilitate algorithmic trading, the ability to leverage your account with low day-trading margin requirements, as well as competitive fees and commissions. Once you select an exchange, you can create a futures trading account. It takes little to no time. You can also trade futures on a more ad-hoc-basis via OTC transactions with qualified financial intermediaries handling the process. 

Analyze Your Contract

Take time to analyze your contracts constructively, ensuring you understand vital elements specified in the order, including contract size, contract value and tick size. The contract size is the deliverable quality of the specific energy commodity, and the contract value is the commodity's current price multiplied by contact size. The tick size is the minimum or lowest change in the price of a futures contract. Pay attention to the margin requirements. Some brokers like Charles Schwab offer calculators to help you calculate your margin requirements or the amount you need to deposit and keep at hand to trade. 

Place Your Futures Order and Manage Your Trade

At this stage, it's assumed you've got a futures contract in mind (WTI crude oil futures, Henry Hub natural gas futures) and a detailed trading plan, including an exit strategy. You're now ready to establish a position by submitting an order for execution. Enter the commodity symbol into the online futures trade ticket to find and select the specific futures contract you want to trade, then confirm the order details and submit the order. Remember to set up your exit strategy using additional order types like stop orders. Once you submit your order, it'll get routed to the market to be matched with an order to buy or sell your contract.

Suppose you're trading in NYMEX or other regulated exchanges. You can input your orders into the central clearinghouse that matches buyers and sellers. The system is automatic and can clear huge transaction volumes at high speeds and almost no lag. Now that your position is established and a protective order has been put in place to help you manage risk, don't become complacent; try to reevaluate your exit strategy or take action depending on the market's direction. Also, consider diversifying your portfolio to other sectors to maximize returns and minimize losses. 

4 Tips to Successful Investing in Energy Futures 

While the profit opportunities of energy futures can be alluring, like other futures contracts, success necessitates that you master the underlying assets and their applications or end-use. For instance, crude oil has a wide range of applications that help drive its demand and attendant price. Here are some factors driving energy commodities you need to be aware of.

Supply and Demand

Energy products correlate positively with the economy, so a booming economy tends to increase demand, which makes sense since people have more disposable income. Population explosions can also increase demand. Any situation that impacts the transportation sector will also affect energy demand. The weekly Energy Information Administration (EIA) inventory reports are a great way to stay updated with the latest statistics on the demand and supply of energy products.

Seasonality 

Energy products are used for heating and cooling. The implication is that demand will be considerably high during winter and summer, stabilizing during spring and autumn because of a relatively uniform temperature. Fortunately, the seasonality effects have been repeatedly proven and highly predictable, meaning you're unlikely to miss it.

Geopolitical Uncertainty

The energy market isn't a U.S.-specific market; it is international, so you must be well-informed regarding who the key players are. Geopolitical uncertainties between one or more major entities can impact the global energy situation. A good example is the energy crisis that resulted from Russia's invasion of Ukraine. Besides Russia, other important players are the OPEC countries, the U.S., Canada and China. As far as crude oil, coal and natural gas are concerned, you must keep an eye on these countries.  

Some southeast Asian countries are players in renewables and biofuels. Either way, understanding these countries' energy profiles, restrictions, conflicts and global policies can help you understand the global demand and supply dynamics of energy products, enabling you to hedge against geopolitical uncertainty.

Market Dynamics 

Many factors, including prevailing data, forecasts, assumptions regarding the future of the energy market, travel trend analysis by airlines and weather forecasts, drive fluctuations in the price of energy products. Dissecting all this information can help you make an informed decision. 

Benefits of Energy Futures Contracts

Investing in energy futures offers various advantages to investors. Some of the benefits follow.

Low Upfront Capital or Leverage

Leverage involves using borrowed capital to maximize potential investment returns. Like other futures, energy futures are traded using leverage on margins, enabling you to control large positions with little money. However, your losses will be more than substantial if the market moves against your leveraged position.

Diversification 

Most people's wealth is tied to stocks, bonds, high-yield savings and alternative assets like cryptocurrency and real estate investment trusts (REITs). Investing in energy futures can help diversify your portfolio, increasing your profit potential and minimizing risks. You can diversify further with futures contracts from other sectors.

Hedging 

You can protect your unrealized profits or reduce potential losses with energy futures. Energy futures allow you to hedge against the broader market or specific energy products or commodities.

Liquidity 

Energy futures markets are liquid, making it relatively easy for investors or traders to move in and out of positions quickly without high transaction costs.

After-Hours Trading 

Like other futures contracts, energy futures allows after-hours trading, which makes for flexibility and helps you access opportunities whenever you see them.

Drawbacks of Energy Futures Contracts

While it offers a lot of benefits, it can also be disadvantageous. A few of the disadvantages are:

Risk 

Investing in energy futures contracts can be risky. The price of energy commodities is often influenced by world events, including geopolitical uncertainties, pandemics and war, making it hyper-volatile even when demand and supply are in equilibrium. This type of investment is best left to expert investors.

Over-Leveraging 

While leveraging can help you optimize returns with low capital, it is a double-edged sword. When the market moves in the opposite direction, you'll fully account for the losses and get a margin call, meaning that leverage amplifies your losses.

Loss of Value on Expiration 

Energy futures come with an expiry date which you must be conscious of; otherwise, you may have to physically deliver if the position remains open till expiration. As it nears expiration, energy futures may lose value or become worthless. However, you can avoid this situation by rolling your contract forward to a longer date as it nears expiration.

Lost Opportunity 

An energy commodity producer that accepts a futures contract to sell may lose out if the price increases.

Examples of Energy Futures

Different types of energy futures contracts are available for investors or traders. Each type has its underlying commodity, contract size, tick size and expiration date. Some popular examples are: 

WTI Crude Oil futures: The underlying commodity is WTI crude oil. The contract size is 1,000 U.S. barrels (42,000 gallons), the tick size is 1 cent ($0.01) per barrel ($10 per contract) and it expires on the third business day before the 25th calendar day of the month preceding delivery month. It is primarily traded on NYMEX with ticker CL. 

Brent Crude Oil futures: The underlying commodity is Brent crude oil. The contract size is 1,000 U.S. barrels (42,000 gallons), the tick size is 1 cent ($0.01) per barrel ($10 per contract) and it expires on the last business day of the second month preceding the delivery month. It is primarily traded on ICE with the ticker BRN. 

Henry Hub natural gas futures: The underlying commodity is natural gas based on the Louisiana Henry Hub natural gas price. It is the most prominent global natural gas future and trades on NYMEX with the symbol NG. The contract size is 10,000 MMBtu, the tick size is 0.0001 per MMBtu ($10 per contract) and it expires three business days before the first calendar day of the delivery month.

As a wrap-up, understanding your tick size, contract size and the prevailing price of your contract can help you calculate your profit or loss. For instance, the WTI crude oil contract has a tick size of $0.01 per barrel and a contract size of 1,000 U.S. barrels. 

If the current price of WTI futures is $74.50 per barrel, the contract value is given by: current price x contract size = $74.5 x 1,000 = $74,500

The dollar value of one-tick move = tick size x contract size = $0.01 x 1,000 = $10 per tick 

If initially you bought one WTI contract at $73, and the current price is $74.50. 

Your profit-per-contract is $74.50 - $73 = $1.5.

And your contract has moved $1.50 divided by $0.01 = 150 ticks.

The total moves in dollar amount = 150 ticks x $10 per tick = $1,500.

Your total profit = the number of contracts x $1,500.

 You can calculate losses using the same approach. 

Energy Futures for Risk and Reward

Energy futures contracts are derivative contracts in which energy products and commodities like crude oil and natural gas are the underlying assets. The market is highly liquid and can serve as an effective hedging instrument for diverse market participants. Energy producers and consumers can also use it to lock in prices, thereby preventing losses from unfavorable price swings. It also offers an avenue for portfolio diversification among retail and institutional investors. 

Energy is the driving force of civilization. Population explosion, globalization, economic and technological advancement and climate change will continue to drive demand for energy products. The energy futures market is poised to grow and become even more advanced. Increased adoption of eco-friendly energy alternatives will further expand investable assets within the market, meaning more opportunities for investors to capitalize on and reap returns or for diversification purposes.  

However, to successfully capitalize on the market's opportunities, you must constructively research and understand the core factors influencing demand for each underlying commodity while staying updated with relevant industry information. You can trade or invest in energy futures via regulated exchanges (like NYMEX), traditional brokerage and OTC.

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