TANA-NOMICS: Oil Price and Fry-Bake

TANA-NOMICS: Oil Price and Fry-Bake


For the last few weeks oil has been trending all over social media as if it pushed away Iwer George’s hand on top a music truck or had a big wedding and charged everyone to come to the reception. This had me wondering whether people really understood what is meant by “oil price”.

Did you know that the term “oil price” actually refers to the price of 1,000 barrels of oil traded on an exchange? Don’t feel bad if you thought you could walk into Peake’s and ask for 1 barrel of oil and pay US$30 for it. Nope, the price of oil is actually the price of a futures contract.

Which brings me to the topic at hand. A futures contract or just “futures”, is a binding agreement that gives a buyer the OBLIGATION to purchase or a seller the OBLIGATION to sell, a specific commodity/financial instrument, at a predetermined price on a predetermined day in the future. It doesn’t matter what the actual price is when the contract expires, you MUST transact at the contract price.

Yes friends, fire up the flux capacitor in the Delorean and jump on your hoverboard. We’re dealing with the future!

Futures are standardized contracts that specify the number of units, price, method of delivery etc. There are futures contracts on all kinds of things including oil, gold, wheat, corn, bonds and stock indexes. Alas, there are no futures contracts on fete tickets or Carnival costumes.

So when you see the price of oil is quoted at US$30 per barrel, that’s actually the price of the nearest futures contract for delivery, currently April 2020.

How do we price an item today for delivery in the future? Well I’m glad you asked but after my explanation you might regret that you did.

Well, commodity traders use their magic 8-ball or read Royal Castle chicken bones on the ground of course. Actually no, but I’m not going to confuffle you with the mathematical model used to price futures. All you need to know is that it factors in the current price (spot), interest rates, time, storage costs, dividends and even a variable for convenience.

There are two ways to fulfill a futures contract, there’s cash settlement or physical delivery. Most contracts are settled in cash. Could you imagine if I, with my fass self, purchased an oil futures contract and trucks show up and drop off 1,000 barrels of crude oil in the car park of my office?? The security guards would not be amused.

Futures can be used for hedging or speculation. Hedging involves protecting a position or an asset from losses. Here are a couple examples of hedging:

Let’s say you’re a producer of “tambran” and bene balls and there is an active Tobago sweets futures market. You’re worried about the slump in the economy and the price you could sell your various balls for in the future. So you enter into a futures contract today to sell your balls at a specified price in the future. Now you can rest easy as your balls are hedged and secure.

On the flip side, let’s say you’re the biggest “fry-bake” mogul in the western hemisphere, therefore you use a lot of vegetable oil. You don’t want to risk a spike in the price of vegetable oil. So you enter into a futures contract today as the buyer to lock in the price of your raw materials in the future. Now your vegetable oil input price is hedged and secure so all you have to do is focus on making sure your bake is light, fluffy and golden brown.

Speculation is basically making a bet on the direction of the price of futures and buying or selling a contract before it expires to take advantage. If you expect toilet paper or eddoes futures prices to increase then you would buy a contract today and hope to make a profit on the difference any time before expiry.

There are a lot more gory details when it comes to futures. Futures are part of an obscure, nebulous, enigmatic, cryptic area of finance called “derivatives” which is almost as confusing as Nailah’s fake language. Wait until we get to options and swaps.

TANA

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