Futures Education

Energy

Trading in the energy futures market began in 1979 and, like metals, trading is primarily conducted on the New York Mercantile Exchange. The NYMEX hosts the trading of crude oil, both Brent and light sweet crude, natural gas, heating oil, gasoline, coal and electricity. Next to interest rate futures, energy, and especially oil, is the king of the world futures markets.
Energy is perhaps the most strategic material in world commerce and its price can be exceedingly volatile. The availability and price of energy has a direct bearing on the competitiveness of the economies of industrial and agricultural nations alike. Countries that depend on the sale of energy resources have a vital interest in its price.
The prices quoted are used as global benchmarks for the underlying energy markets, an indication of the confidence that the market places in the integrity of these transactions.

Energy and economics

Interest rates and energy prices have a significant impact on everything that happens in the world. Think about it. When you wake up in the morning, nearly everything you touch, use, or experience is somehow tied to interest rates or energy. You live in a home that has a mortgage. That home is warmed with natural gas or electricity. The plastic bowl that you put your morning cereal in was produced from petroleum products. Most cars on the road are leased or financed and are fueled by gasoline. Interest rates and energy make the world go round!
Energy prices and interest rates generally move in the same direction when viewed over the long term. Rising energy prices often lead to inflation, and eventually inflation will lead to an increase in interest rates. When trading energy futures keep a close eye on the bond market and federal funds rate to help you understand the general direction of the energy market.
Another important economic consideration when trading energy futures is supply. Generally more important than demand, supply is possibly even more important than interest rates. The world runs on oil. Any changes or threatened changes in the oil supply are immediately reflected in price. Your objective as an energy trader is to consider the effects of events on the supply and forecast the impact on energy prices.
Often refineries are a bottleneck in the supply lines of oil. You will often read articles or hear news stories that talk about disruptions at major oil refineries. Even if oil is in good supply, if the refineries can't turn it into gasoline or heating oil, the supply of those products is impaired and energy prices will rise across the board.
With this in mind let's introduce the most traded products in the energy futures market.

Crude Oil

Crude oil is the foundation of energy market. Crude oil is the raw material for the production of gasoline, diesel, jet fuel, boiler fuels and thousands of petrochemicals.
Dominating the energy futures market, crude oil accounts for roughly 40% of world energy supply. This market share and versatility make it the world's most strategic and actively traded physical commodity. Since the introduction of the light sweet crude oil futures contract in 1983, it has evolved into the world's most liquid forum for crude oil trading.
Petroleum is commercially produced on every continent except Antarctica, and in most of the world's nations. Oil is produced in the suburbs of Paris and downtown Beverly Hills. It flows from prolific wells in the Arctic wilderness of Alaska and Canada and the tropical jungles of South America and Southeast Asia. In the United States, all but a handful of states are oil producers.
The world's three largest oil producers are Russia, Saudi Arabia, and the United States. More than half of the world's economically recoverable reserves are found in the Middle East. Since the early 1970s, the oil market has experienced some extreme price volatility, the most recent being a spike in oil prices to nearly $150 a barrel in 2008 related to geopolitical disruptions and a significant devaluation of the U.S. dollar.

Light sweet crudes are preferred by refiners because their low sulfur content and yields of high-value products such as naphtha, gasoline, middle distillates, and kerosene. Since crude oil production involves extensive commitment of resources, often many years in advance, the Exchange's light sweet crude oil futures contract is the most far-reaching of its products, listing contracts up to seven years forward.
Brent crude oil, a light sweet North Sea crude is also used as an international pricing benchmark.
Light Sweet Crude futures contracts trade in units of 1000 barrels. The minimum price fluctuation is $0.01 per barrel and the tick value is $10.00.
Brent Crude futures contracts trade in units of 1000 barrels. The minimum price fluctuation is also $0.01 per barrel and the tick value is $10.00.

Gasoline

Gasoline's primary use is as fuel for automobiles. Gasoline is the single largest volume refined product sold in the United States and accounts for almost half of national oil consumption. Prices are volatile, reacting to political and economic developments that are perceived as being likely to affect the oil industry. Ever-tightening environmental regulations also add to market uncertainty.
The popularity of automobile travel is the primary factor in the demand for gasoline. Retail gas prices are slow to respond to changes in its production costs and the price is relatively inelastic, meaning that even high gas prices at the pump don't seem to have much of an effect on gasoline consumption.
The physical gasoline product underlying the futures contract is reformulated blendstock for oxygen blending (RBOB), a formulation that is blended with ethanol at the truck loading rack. Ethanol use has become more widespread since the phase-out of the additive methyl tertiary butyl ether, which had been used for many years.

Gasoline futures contracts trade in units of 1,000 barrels. The minimum price fluctuation is also $0.0001 per barrel and the tick value is $4.20.

Heating Oil

The principle use of heating oil is in furnaces to warm residential and commercial buildings. Heating oil accounts for about 25% of the yield of a barrel of crude, the second largest "cut" after gasoline.
The heating oil futures contract is also used to hedge diesel fuel, which is chemically similar to heating oil, and jet fuel, which often trades in the cash market at premium to heating oil futures.
Like gasoline, heating oil is relatively inelastic, although consumers will lower their thermostats when prices are extremely high. If prices continue to remain high, consumers will employ substitution products such as electricity or natural gas, provided energy prices have not increased across the board.
A wide variety of businesses, including refiners, wholesale marketers, heating oil retailers, trucking companies, airlines, and other major consumers of distillate fuel oil, have embraced this contract as a risk management vehicle and pricing mechanism. The imposition of federal sulfur standards for diesel fuel has the potential to increase price volatility in some markets.

Heating Oil No. 2 futures contracts trade in units of 1,000 barrels. The minimum price fluctuation is also $0.0001 per barrel and the tick value is $4.20.

Natural Gas

Natural gas is found throughout the world, with leading producers being the United States, Russia and Canada. Natural gas plays a major role in the energy profile of the United States, where it accounts for almost a quarter of total energy consumption.
Natural gas is formed deep within the earth by the decay of organic matter under heat and pressure from many layers of overlying rock and sediment. It is obtained by drilling. Because of its relatively high transportation cost, most natural gas is consumed in the country where it is produced. In the U.S. it is transported to end users through a network of interstate pipelines.
In its raw form, natural gas is composed of several gases and water. The natural gas delivered to your home by the local gas company has been refined to 93% methane, which is colorless and odorless. Sulfur compounds called mercaptans are added to create an odor to warn of gas leaks.
Industrial users and electric utilities together account for approximately half of the market; commercial and residential users combined are approximately 40%. Since the enactment of the Natural Gas Policy Act of 1978, the industry has changed from one that is almost totally regulated to one that operates largely as a free market.

Natural Gas futures contracts trade in units of 10,000 million mmBtu. The minimum price fluctuation is also $0.001 per mmBtu and the tick value is $10.00.

Coal

Coal, which helped power the industrial revolution, plays a significant role in the U.S. energy industry and the economy overall. It is the principal fuel for generating electricity in the United States, accounting for approximately 50% of the nation's total power output.
The New York Mercantile Exchange launched the physically delivered Central Appalachian coal futures contract in 2001, bringing the energy complex full circle to cover all principal fossil fuels. The Central Appalachian futures contract is based on barge delivery along the Ohio and Big Sandy rivers.
The United States has more high-quality coal than any other country, with nearly 30% of the world's bituminous coal reserves. Only China produces more bituminous coal than the United States, but almost all of China's production is consumed domestically. U.S. coal exports, chiefly Central Appalachian bituminous, make up a significant part of the world export market and are an important factor in world coal prices. At current rates of recovery and use, it is estimated that U.S. coal reserves will last more than 250 years.
Because coal is a bulk commodity, transportation is an important aspect of its price and availability. Railroads carry more than half of the coal mined in the United States, often hauling the coal in unit trains of 60 to 120 cars. The inland waterway system is the other major mode for coal transportation.
Coal futures contracts trade in units of 1,550 tons. The minimum price fluctuation is also $0.01 per ton and the tick value is $15.50.

Electricity

Electricity lends itself to futures trading because it meets the three broad criteria needed for successful futures markets: prices are volatile, there is a large, diverse universe of buyers and sellers, and the physical product can be exchanged.
The Exchange provides a series of financially settled futures contracts for on-peak electricity transactions at principal market hubs in New England, New York State, the Mid-Atlantic states, throughout the Midwest, Texas, California, and other western locations.
The contracts are for the on-peak and off-peak periods as defined by the North American Electric Reliability Council, the power industry's operations coordinating group.
Unlike traditional futures contracts that represent a fixed quantity, such as 1,000 barrels of crude oil, or 1,550 tons of coal, the total quantities of power represented by most of the electricity contracts are variable because the number of on-peak and off-peak hours can vary from month to month.
For example, each financially settled monthly PJM futures contract covers 40 megawatt hours (Mwh) for each peak day of the month. The number of peak days can range from 19 to 23, depending upon the month, and the number of megawatt hours represented by the monthly futures contracts will vary:

• 19 peak days per month = 760 MWh per contract.
• 20 peak days per month = 800 MWh per contract.
• 21 peak days per month = 840 MWh per contract.
• 22 peak days per month = 880 MWh per contract.
• 23 peak days per month = 920 MWh per contract.

Electricity futures contracts trade in units of 40 megawatt hours during the peak day. Depending on the number of peak days in the month, the number of megawatt hours will vary as shown above. The minimum price fluctuation is also $0.05 per Mwh.

Summary

The energy markets are rooted in real companies making decisions to hedge their future price risk and speculate in future price direction. The energy market is about real people making real decision about how much energy they will need to run their businesses in the next few months to years. Prices in the energy market are based on real life circumstances that aren't generally influenced by the kind of fictional analysis of Wall Street analysts pushing stocks.
There are a number of guidelines used to keep abreast the energy markets. First, be mindful of OPEC, the trade organization that controls the bulk majority of the world's oil supplies. Changes in OPEC policy will influence the supply of energy and have reaching affects on price. Second, energy supply is made up of production and refining - both play an equally important role in the price and trend of energy. Third, the potential for disruptions can happen all along the supply line. Everything from geopolitics to weather events have the capacity to disturb energy prices. Make sure you are aware of global political and natural weather events. Finally, keep close tabs on interest rates, the dollar and bond markets for signals in the energy markets.