This archive report was first published on 25 May 2020.
Oil Price Decline and Futures Markets: A Complex Relationship ¶
As the global economy grapples with the impact of the COVID-19 pandemic, the oil price decline has been a major talking point. But what exactly are futures markets, and how do they relate to oil prices?
According to Terry Adembesa, Chief Officer, Derivatives Market at the Nairobi Securities Exchange, futures markets originated from burgeoning oil and grain markets. These markets created a need for farmers to secure a price at one point in time, store the grain, and deliver it at a later point in time.
Today, futures markets are a global phenomenon, with financial instruments such as currencies, bonds, and stock indices being traded alongside commodities like oil and precious metals. The most traded instruments in the global derivatives markets are financial derivatives.
There are two main types of derivatives: forward and futures contracts. A forward contract is a bilateral and customized agreement between two parties, where one party agrees to buy an underlying asset at a future date at a price established at the start. A futures contract, on the other hand, is a standardized and public transaction that takes place on a futures exchange.
On entering the transaction, the exchange enables the trading and settlement of the contract through a daily market-to-market procedure. Profits and losses are charged and credited to participants' accounts each day, preventing the accumulation of losses for the party on the losing side of the trade.
The primary function of futures markets is to provide key information about the prices of underlying assets. The price of a futures contract serves as the price that can be accepted by those who trade in the contract in lieu of facing the risk of uncertain future prices. But most importantly, the function of futures markets is to hedge by seeking to avoid the uncertainty of future prices by locking in a price for a future transaction.
On Monday, April 20, 2020, the WTI crude prices fell below zero for the first time ever, settling at negative $37.63. This event highlights the complex relationship between oil prices and futures markets.
