A Futures Market Response to Oil Price Volatility

Abstract

The volatility of oil prices has expanded dramatically over the past twenty years. New mechanisms, including futures and forward contracts, options on futures and “over-the-counter” options have been developed to deal with the uncertainty of buying or selling of petroleum in the highly competitive markets that now characterize the oil situation. Futures contracts — agreements to buy or sell oil at a particular time in the future — are the core of the new mechanisms. Since futures market prices move in concert with cash (“wet”) market prices, futures can be an effective substitute for wet barrel transactions. Buyers of options gain the advantage of futures trading — the right to buy without the obligation to do so — for a fee. Futures markets provide open pricing, not subject to special, hidden arrangements. Contracts are available for crude oil, heating oil, gasoline, propane and natural gas. All contract terms are fixed so that only price need be negotiated. This is how so many contracts are traded rapidly. Financial institutions are learning that futures, when used in a competent hedge program, provide safety and allow for business expansion.