I’m seeing a lot of headlines like this: Oil falls below $38 - OPEC cut ignored. I chose the CNNMoney article for a reason. It makes mention that the February contract is the front-month contract starting tomorrow. The February contracts are currently trading for $43.11. If you are a speculator and don’t actually want to take delivery of oil, you sell your contracts before the end of the contract run.
An example: airlines buy fuel, but protect themselves against future fuel price increases by buying oil futures. They don’t actually want barrels of oil, but they figure that if the price of oil goes up, so too will their fuel prices. Since they sell their tickets ahead of time, they want a hedge. If the price of oil drops, so too will their fuel, but since they already incorporated the fuel cost into the ticket price, they don’t care. If the price of fuel (and oil) rises, the ticket price would have been insufficient without the hedge. They would have lost money without their hedge.
Many traders prefer to roll their contracts. They sell one month and buy the next month as time goes on. They do this for a couple reasons. First, the front month is typically more liquid than future months. Traders like trading liquid contracts because it’s more likely that they can withstand small shocks (better prices). Second, there’s the issues of contango and backwardation (the opposite of contango). Right now, the oil market is “in contango.” The further in the future you go, the more expensive the oil contract. If you happen to have a big warehouse, you could make a profit right now by buying oil contracts in the front month and selling contracts far in the future. You have to take delivery of the oil and hold it until the future date arrives. It’s guaranteed profit, because you get paid up front. Even if the price of the future oil contracts fall, you don’t care. You’ve already been paid. Anyway, since the market is in contango, buying contracts further in the future potentially costs more than buying now and rolling the contract each month. To be honest, I think the liquidity is more important than contango right now.
Anyway, that was a long winded justification for why I get irritated by articles that discuss big price swings in the front month contract right near the expiration date. Are they going to talk about a huge bump in the price of oil tomorrow?
