The strange world of futures contracts

There was this news report in the last few days about the price of oil going negative to -$40 per barrel, giving the impression that oil producers were now paying people to take their oil. Of course, that could not be strictly true. It is not as if your local gas station was paying customers to fill their tanks. In actuality, gas prices were trading normally, though the prices have been dropping due to the lowered economic activity because of the pandemic leading to an oil surplus.

But this story does illustrate one of the pitfalls of what are known as futures trading contracts where, as I understand it, people enter into contracts to purchase a given amount of an asset at a certain price at a specified date and time in the future, irrespective of the price at the time that they entered into the contract. In this case, the asset was oil and the due date when the contract fell due was Tuesday.

An oil producer needs to sell their oil. They may use futures contracts do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.

Many traders on futures contracts have no interest in actually owning the oil. Instead they are betting that the price of oil will rise before the expiry date and so they can sell the contract to someone else at a profit. The buyer will in turn sell that contract before the due date.

Retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, but they may interested in capturing a profit on the price moves of oil.

For example, it is January and April contracts are trading at $55. If a trader believes that the price of oil will rise before the contract expires in April, they could buy the contract at $55. This gives them control of 1,000 barrels of oil.

The final profit or loss of the trade is realized when the trade is closed. In this case, if the buyer sells the contract at $60, they make $5,000 [($60-$55) x 1000). Alternatively, if the price drops to $50 and they close out the position there, they lose $5,000.

But what happened was that the price of oil has been dropping and holders of the contracts may have held on to them for too long, hoping that the price may go up and reduce their losses. No one wanted to buy the contracts because the oil storage facilities were packed due to the low demand. This meant that the holder of the contract at the specified time would have to buy the oil at the contracted price and, worse, would have to take physical possession of the oil, which of course is impossible for most of the traders to do and those who could would have to find expensive new storage facilities for it. So the owners of these contracts were desperate to unload these contracts on Tuesday and were willing to pay people to buy them, hence the negative price. Presumably the final purchasers had access to storage facilities.

I heard about futures contracts a long time ago where the asset concerned was pork bellies. Apparently pork bellies are a very popular food item. I was intrigued by the idea that if one mishandled the futures contract for it and did not unload it in time, one might find truckloads of pork bellies dumped on your front yard. I suspect that that is not quite what happens but that idea gripped my imagination.

This is reason #347 why I steer clear of any direct involvement with the stock market.


  1. mikey says

    Can we stop calling these people “traders” and “portfolio managers,” and call them something more accurate, like ‘parasite’?

    And on a related note, let’s drop the “lobbyist” euphemism, and use ‘bribers’ instead.

  2. xohjoh2n says

    This is reason #347 why I steer clear of any direct involvement with the stock market.

    Well, there may be other reasons to avoid the stock market, but the above kind of disaster can only really happen on commodities futures, which are different and generally not remotely useful for the individual investor. If you hold on to Microsoft stock for too long it’s not like they’re going to start disassembling parts of One Microsoft Way and try and deliver it to your driveway. And even derivatives, well you can lose an awful lot of money but you’ll never have to take delivery of 28,000 tons of coal…

  3. lanir says

    This is definitely one of the more readily apparent issues with some forms of trading on the stock market. I would assume there’s a disposal fee written into contracts like this.

    Another issue with investing is that you literally can’t get into it without a set amount of money to throw at it. I’ve had places I’d have liked to invest in to some degree but they could only allow investors who could throw I think it was $10,000 at it or they would get into legal trouble. At least that was how I understood it. This is pitched as protecting the little guy but in practice it’s just a barrier to entry that keeps workers from owning any part of companies.

  4. brucegee1962 says

    @1 mikey
    From my understanding these traders are actually providing value to society. Here’s what I got from my reading on the subject:

    Over the past month, the main oil producers (the U.S., Saudi Arabia, and Russia) have been having languid, on-again off-again discussions about “maybe when people aren’t travelling as much, we ought to cut production a little bit. Umm, you go first.” The problem is, shutting down an oil-producing site is incredibly expensive. The stuff’s under pressure, so you’ve got to cap it off somehow. Then later, when demand presumably returns, you’ve got to re-open the thing. So nobody really wanted to do it, even though nobody really wants or needs oil at the moment.
    The negative futures market was a message directly to those producers: “WE ARE RUNNING OUT OF STORAGE SPACE! TURN OFF THE SPIGOT NOW, OR THE WORLD WILL BE FLOODED WITH A TOXIC CHEMICAL WE CAN NEITHER STORE NOR DUMP!” Hopefully that message will be received. The market (through the traders) gives the producers an economic incentive to do what they need to do.

  5. Allison says

    Can we stop calling these people “traders” and “portfolio managers,” and call them something more accurate, like ‘parasite’?

    The usual term is “speculator.” And they do serve a purpose: they basically assume the risk of price fluctuations.

    Also, AFAIK, there’s no actual delivery to the holders of futures contracts (in contrast to holders of forward contracts.)

    In principle, when the contract comes due, you “settle up” in cash: that is, you either receive or pay the difference between your position and the spot price (the price the commodity is selling for on the open market.) It’s the equivalent of buying or selling for the position price and selling or buying at the spot price. The idea is that someone who actually wants to buy or sell the commodity takes a position, and on the day of delivery, the speculator makes up or earns the difference between the agreed-on price and the actual market price, so that the actual buyer/seller effectively gets the agreed-on price.

    Actually, what they do is to do this settlement every trading day, except that instead of the current open market price, they use something called the “settlement price,” which is a price that the exchange calculates each day after the trading is done for the day. The purpose of this is to avoid hitting the holders of the contract with an enormous difference on the expiration day, when they could in principle skip town. (This is the catch with forward contracts.) Instead, they have to keep a certain amount of money in their account and it gets increase or decreased each day.

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