What are oil futures?

Oil futures contracts are legal agreements that require holders to buy or sell crude oil at fixed prices on designated dates in the future. The price of oil is locked in at the start of the contract, which makes oil futures useful for hedging price volatility and speculating on movements in global energy markets.

Oil futures are traded on public, centralized, and heavily regulated exchanges such as NYMEX (New York Mercantile Exchange) for WTI futures and ICE (Intercontinental Exchange) for Brent Crude futures. The exchange matches counterparties and “clears” every trade. This is the opposite of spot and forward markets where oil trades are negotiated privately between counterparties over the counter (OTC) without a central intermediary.

As the clearinghouse, the exchange is the official counterparty to everyone and bears counterparty risk on behalf of market participants. It acts as the buyer to every seller and the seller to every buyer, and takes responsibility for obligations to buy or sell oil owed by both parties in an oil futures contract. This minimizes counterparty risk for market participants: if one side of a contract defaults on their obligations, the exchange must cover those obligations. The process by which the original contract between buyer and seller is replaced with separate contracts between each party and the exchange is called “novation.”

Daily settlement in futures markets

The value of an oil futures contract is fixed at the time of sale. If Alice buys a contract for 1,000 barrels of oil at $70 per barrel from Bob, the contract is valued at $70,000 (1,000 barrels x $70). However, the contract is periodically revalued to reflect the current price of oil on the futures market.

To revalue a contract, the exchange compares the locked-in price for oil to the final market price at the close of business. For instance, if the price of oil climbs to $75, Alice’s contract will be revalued at $75,000 (1,000 barrels x $75). The process is known as daily settlement because that’s when the exchange settles profits and losses traders incur on their open futures positions.

A trader enters a long position by buying oil futures and a short position by selling oil futures. In our example, Alice is the long trader and Bob is the short trader. The settlement price is the official closing (futures) price of oil posted by the exchange at the close of business and determines whether a position is in profit or loss after the contract is revalued.

In the oil futures market, a long position makes profit when the settlement price rises above the locked-in price and loses money when the settlement price is lower. Conversely, a short position makes profit when the settlement price falls below the locked-in price and loses money when the settlement price rises above the locked-in price. Since Alice is long and Bob is short, a profit for Alice is an equivalent loss for Bob and vice versa.

The exchange settles daily profits and losses (P&L) using traders’ margin balances. Margin is collateral deposited before creating a position and is usually a percentage (3 to 12 percent) of the total value of oil controlled by a futures contract. The margin acts as a good-faith financial guarantee that a trader will fulfill the obligation to cover losses incurred on an open position.

Whenever a trader loses money on their position, that amount is deducted from their margin balance and added to the other trader’s margin balance. So, if Alice’s position is in profit after the contract is revalued, the exchange deducts money from Bob’s margin account to pay her profit. The reverse occurs if Bob, not Alice, is the one in profit: money debited from Alice’s margin balance is credited to Bob’s margin balance.

If the exchange has a 5% margin requirement, that means Alice and Bob have to deposit $3,500 as margin. This deposit is called the initial margin and is separate from the maintenance margin. The maintenance margin is the minimum margin balance a trader needs to keep their futures position open and is usually set slightly lower than the initial margin.

Typically, exchanges set the maintenance margin as a fixed percentage of the initial margin. A hypothetical maintenance margin requirement of 80% means traders must keep margin balances above 80% of the initial margin. Applied to our example, an 80% maintenance margin threshold requires Alice and Bob to have at least $2,800 in margin after accounting for daily profits and losses.

If a trader’s margin balance drops below the maintenance threshold, the exchange issues a margin call and asks the trader to deposit fresh funds into their trading account to bring the margin back up to the required level. If the trader fails to honor the request, the exchange liquidates and closes the position. During a liquidation, the exchange places an offsetting trade and uses the trader’s remaining margin to collateralize the replacement position.

For example, if Alice is long oil futures and fails to meet a margin call, the exchange closes her position by selling an offsetting futures contract from her account. The trader who buys that contract effectively takes Alice’s place in the market and ensures the market is balanced by providing collateral to support the long side of the exchange’s book.

This way, even though the exchange is the official counterparty to everyone and bears counterparty risk, it ideally has zero net financial obligations because long and short positions are perfectly balanced and cancel each other out. As long as every collateralized long position is matched by a collateralized short position, losses on one side of the market can be covered by gains on the other without the exchange having to use its own funds.

Why daily settlement matters for oil futures

In oil futures markets, daily settlement ensures that paper losses do not accumulate until the contract’s expiry date. The expiry date is when the oil that the holder of an oil futures contract actually has to buy or take delivery of physical oil. Although the contract expires much later, traders start accumulating paper profits and losses as the market price of oil moves away from the initial locked-in price.

To understand why daily settlement matters, consider what would happen if exchanges allowed paper profits and losses recorded by traders to accumulate until contract maturity. In the earlier example, Alice and Bob enter long and short positions, respectively, at $70. If the price of oil climbs to $75, Bob makes a paper loss of $5,000 ($5 x 1,000 barrels) because the current market price is higher than the price he locked in when he sold the oil futures contract. Alice makes an equivalent paper profit ($5,000) because the oil she bought for future delivery is now worth more than what she agreed to pay for it initially.

These profits and losses only exist “on paper” and are not realized until the transaction is completed. Specifically, Bob doesn’t realize the full financial loss until he delivers oil below the current market price, nor does Alice realize the corresponding gain until she takes delivery of the oil below the current market price. This is closer to what happens in oil forward markets, where paper profits and losses remain unrealized until the contract matures and parties have to buy or deliver physical oil at locked-in prices.

Even though paper profits and losses only exist in financial records, they have real-world consequences. A trader that accumulates large losses before an oil contract matures is more likely to default on their obligations. Take, for example, the scenario where Bob makes significant paper losses on his short oil futures position before his contract with Alice matures.

If Bob is an oil producer, he might be able to write off the loss and honor the contract with Alice because he owns physical oil. However, if Bob doesn’t own oil and has to buy it before delivering to Alice, he has to put up additional funds to cover the difference between how much oil cost when he sold the futures contract and what it costs at the time of delivery. If the paper losses keep piling up (e.g., because a short-term shortage is causing daily price spikes), Alice may start to worry about the possibility that Bob may default on the agreement.

If Bob has the funds available, or can secure a line of credit, he should have no problem buying oil at the new price and delivering it to Alice as promised, even if it means making a loss on the trade. However, if Bob cannot cover the shortfall, meaning he cannot buy oil at the new price, then he will inevitably fail to deliver the oil to Alice.

This is a classic example of counterparty risk: if one party to a transaction fails to follow through on their obligations, the other party has to bear the consequences. In this scenario, Alice has to bear the consequences of Bob defaulting on his obligation to deliver the oil according to the terms agreed previously.

This risk is particularly pronounced in oil forward markets. Like oil futures, oil forwards are financial instruments that allow traders to lock in prices for crude oil to be delivered in the future. The difference is that oil forward contracts are negotiated directly between buyers and sellers rather than cleared by an exchange, which exposes both parties to greater counterparty risk.

For instance, counterparties may fail to buy or sell oil once the delivery window arrives because they have accumulated significant paper losses in the lead-up to the contract’s maturity date. The previous example shows how Bob accumulates enough losses and loses the ability and willingness to fulfil his obligations, but Alice may be the defaulting party in a different scenario. If oil prices fall sharply (e.g., because of a supply glut), Alice may accumulate enough losses to make Bob doubt her ability to pay for the oil when the time comes.

Alice’s situation will be different depending on how she intended to finance the purchase. In the first scenario, Alice may have borrowed money to buy oil on the assumption that she would be able to resell the oil at a good price and make a profit. The potential profit would be what she has left after accounting for the cost of borrowing the money, including the principal and total interest. But if oil prices collapse, the resale value of the oil may be too low to make a profit: Alice might be able to repay the loan principal and interest but have nothing left over. In a worst-case scenario, she may actually make a loss because the resale value cannot cover the cost of repaying the loan and accumulated interest.

In the second scenario, Alice may have planned to borrow money to pay for oil shortly before delivery. However, a crash in oil prices might complicate the plan. Concretely, if the contract with Bob requires her to buy oil at a price that is substantially higher than the current market value, lenders may hesitate to finance the purchase because the proceeds from reselling the oil cannot repay the principal and interest. In both scenarios, a sufficiently large drop in oil prices in the lead-up to the contract maturing may reduce Alice’s ability and willingness to honor her obligation to buy oil from Bob at the agreed price.

Futures markets address this flavor of counterparty risk by marking open positions to market every day and converting paper losses and profits into real money. Positions are marked to market as part of the daily settlement process: the mark-to-market (MTM) procedure simply updates the value of a position to match its current market value. If Alice opened a long position worth $70,000 (1,000 barrels at $70 per barrel) on Monday, but oil is valued at $65 per barrel at the end of trading on Tuesday, her position is now $65,000 after the exchange marks it to market. If oil is valued at $75 instead, then her long position will be worth $75,000 after it is marked to market.

Those profits and losses become realized once the exchange credits and debits money from traders’ margin balances. We explained this process previously: if Alice makes a profit, which means Bob loses money, her balance is credited with funds deducted from Bob’s margin account; if Bob makes a profit, which means Alice loses money, his balance is credited with funds taken out of Alice’s margin balance. Losses don’t pile up until the contract expires.

This design greatly reduces counterparty risk for market participants trading oil futures. By the time oil futures contracts expire, traders who took opposite sides of an oil trade would have already exchanged the accumulated cash difference between the contract’s original value and the current market value of oil.

To illustrate, imagine Alice is representing a commercial oil consumer (e.g., a refinery) and buys a one-month WTI futures contract for 1,000 barrels from Bob, locking in a future purchase price of $70 per barrel. However, the price of oil climbs to $170 by the time the contract is set to expire. Alice’s long position profits if the market price rises above the original purchase price she locked in: in this case, her total profit is $100,000 ($100 per barrel).

Since profits and losses are settled daily, Alice would have already received the $100,000 before the contract expires. Now, if Bob defaults and fails to deliver the oil at the locked-in price of $70, Alice can buy 1,000 barrels from someone else at the new market price of $170. Her effective cost is still $70 per barrel because the $100,000 profit on her long position cancels out the extra $100,000 she has to pay to cover the difference between her locked-in price and the new market price. If Alice’s goal was to hedge rising oil prices, then her strategy worked.

The same idea could apply to Bob in different circumstances. Suppose Bob represents a commercial oil producer (e.g., an international oil company or IOC) and sells a one-month WTI futures contract for 1,000 barrels to Alice, locking in a future sale price of $70 per barrel. However, the current price of oil drops to $40 before the contract is set to expire. Bob’s short position profits when the market price of oil falls below the original sale price he locked in: in this case, Bob’s profit is $30,000 ($40 per barrel).

Through daily settlement, Bob will have received the $30,000 before the contract expires. If Alice defaults and fails to buy oil at the locked-in price of $70, Bob can sell 1,000 barrels to someone else at the new market price of $40. Adding the proceeds from the sale ($40,000) to the profits from the short futures position ($30,000) leaves Bob with $70,000, which is the same sale value he locked in earlier. If Bob’s goal was to hedge falling oil prices, then his strategy worked.

Speculation and leverage in futures markets

Speculating on oil prices with futures

The same mark-to-market mechanism is what makes oil futures useful for speculation. Suppose Joe buys a WTI futures contract for 1,000 barrels at $70 because he expects oil prices to rise. If the futures market prices oil at $80 at the close of trading the next day, Joe’s long position makes a $10,000 profit ($10 on every barrel). He doesn’t have to hold the contract until expiry and can exit immediately after recording the profit by placing an offsetting trade, i.e., selling the same futures contract at the current market price. The offsetting trade closes out Joe’s long position, allowing him to leave the market without waiting for the contract to expire.

It is relatively easy to exit an oil futures contract and have someone else assume your position because futures contracts are standardized and fungible. The exchange determines the contract specifications, including the quantity and type of crude oil, delivery location, and expiry date. For example, every NYMEX WTI futures contract for a given delivery month has the same specifications: 1,000 barrels of light-sweet West Texas Intermediate (WTI) crude delivered to Cushing, Oklahoma. Standardizing contract specifications makes them easy to trade: contract terms are fixed, so traders can buy and sell oil contracts without having to renegotiate the underlying terms.

Forward contracts cannot be easily exited in the same way because the terms are usually customized between counterparties. A pair of oil forward contracts can specify different crude oil volumes, grades, delivery locations, and expiry dates. The lack of standardized specifications means forward contracts are harder to exchange on a secondary market. To transfer a forward contract to another party, a trader generally needs the consent of the original counterparty, and the parties may need to negotiate a new arrangement. This makes forward markets significantly harder to scale compared to futures markets.

Maximizing trading leverage with oil futures

Another reason oil futures trading is attractive is because it allows traders to maximize leverage. Recall that margin requirements are typically a small fraction of the total value of oil controlled by a futures contract. For instance, an exchange with a 10% margin requirement requires traders to deposit $7,000 as margin for a position that controls oil worth $70,000 (e.g., 1,000 barrels at $70). The leverage ratio here is 10:1 because the trader deposits one-tenth of the value of oil their position represents.

High leverage increases a trader’s profits when the market moves in their preferred direction. Suppose a trader enters a long oil futures position at $70 and the market price climbs to $90 in a single day. That trader makes $20,000 in trading profit if they decide to exit the market immediately after daily settlement.

Leverage maximizes profits, but it also maximizes losses. A relatively small move in the opposite direction can wipe out the capital deposited as margin. If the price of oil falls from $70 to $63, for example, the trader’s long position loses $7,000, equal to the entire amount deposited as initial margin. In practice, the exchange would intervene before a trader accumulates enough losses to wipe out their margin balance.

Exchanges usually have real-time algorithms that constantly calculate the value of open positions based on the current market price throughout the day. If a trader’s paper loss would bring their margin below the maintenance threshold after daily settlement, the exchange issues a margin call immediately without waiting until positions are marked to market at the close of business. If the trader fails to deposit additional funds, the exchange liquidates the position to protect itself from having to cover a default.

Cash settlement vs. physical delivery

What happens after an oil futures contract expires depends on whether it is cash-settled or requires physical delivery. ICE Brent Crude futures are cash-settled, meaning any remaining cash differences between the two parties are settled and no one has to take delivery of physical oil. NYMEX WTI futures require physical delivery of oil if the contract is held until expiry.

Typically, exchanges impose additional requirements as a contract approaches expiry: the buyer must demonstrate that they can pay the full value of the oil, while the seller must prove that they can make delivery under the contract’s rules. If either side defaults, the exchange still bears the immediate financial cost of the failed purchase or delivery while it tries to recover the money from the defaulting trader. An oil futures contract is legally binding, so a trader who defaults is still liable for the financial loss even though the exchange steps in to temporarily cover the loss and keep the market running.

Who participates in the oil futures market?

The various qualities and advantages of oil futures, including standardized contract specifications, centralized clearing, low collateral requirements, secondary market liquidity, and exitable positions, attract a diverse group of participants. Commercial oil producers and consumers trade oil futures contracts to hedge fluctuations in oil prices, speculators use them to profit from correctly predicting market movements, and arbitrageurs exploit differences in oil prices across different markets.

Oil futures address some of the biggest limitations of oil forwards, especially counterparty risk and low secondary liquidity. However, oil forwards still offer certain advantages such as trade privacy and customizability. In most cases, the two financial instruments are treated as complementary, with participants using either one of them depending on their needs and goals for participating in the market for crude oil.

Cover photo by Robert Laursoo