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Earlier we mentioned OPEC is cutting oil production in an effort to boost prices. Well six months ago you could have counted on one hand the number of people predicting that a barrel of light crude would cost around 40 bucks. Back then, oil traders were paying well north of 100 bucks a barrel on the oil futures markets. And there’s the rub.
Those traders weren’t actually buying barrels of oil and wheeling them home. They were paying what they thought a barrel of oil would cost at some point in the future. Which is why they’re called futures.
Yes, it’s confusing, but here to help us figure it all out is Marketplace’s Rico Gagliano. With the latest instalment of The Marketplace Decoder.
Rico Gagliano: OK, let’s jump right in with a definition. It comes from Jeff Carter: he’s an independent speculator and a former director of the Chicago Mercantile Exchange.
Jeff Carter: A future is merely a contract where the buyer agrees to buy a commodity, and a seller agrees to sell a commodity, at a specified price sometime in the future!
He’s laughing because, yes, this is a financial instrument, with a name that actually makes sense! I know, I know, incredible. But just to make sure you understand futures, let’s dramatize the transaction, which we’ll do, ironically, by taking a trip to — the past.
Carter: Futures have been around forever. Chinese traded ’em back in 1100. Uh, rice futures.
At least there’s some evidence they go back that far. So via the magic of radio, let’s imagine what might’ve gone down in a Chinese rice paddy circa 1100.
Chinese rice farmer: Hello, I’m a Chinese rice farmer.
Gagliano: Hey. Nice paddy.
Farmer: Yeah — it’s pretty swank. But I’m worried, man.
Gagliano: Why’s that, dude?
Farmer: ‘Cause there’s way too much rice on the market these days. When harvest rolls around, I’m just praying I can sell enough to cover expenses.
Gagliano: Tell you what. I will promise, right now, to buy half your rice once it’s harvested. On that day I’ll pay you two copper pieces a ton.
Farmer: Sweet! That’ll cover my expenses, with money left over to take the wife to Vegas!
Gagliano: Vegas doesn’t exist yet, but whatever! And you know what – I think rice is going to sell for more than two copper pieces. So I figure I’m locking in a super-cheap price!
Farmer: Hey, let’s write this down in a contract!
Gagliano: Genius! And . . . scene.
So that’s a futures contract. Farmer gets a guaranteed sale. Buyer locks in a potentially low price. Now, in today’s futures markets, traders sell contracts for everything from rice to oil. They don’t plan on ever actually touching those commodities. But by trading the contracts, they can gamble on where they think prices are headed. Kevin Kerr is editor of Global Commodities Alert.
Kevin Kerr: If you think it’s going higher, you want to buy the futures. If you think that oil will go lower, then you can sell it. So you really have to decide which way you think it’s going ahead of time, and then place your bet.
That can be risky — just check out the wild swings in oil futures lately. Kerr says the government may start enforcing rules that could calm the market, though. Which I guess means regulation is the future of futures.
In Los Angeles, I’m Rico Gagliano for Marketplace.
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