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1 The futures markets Introduction and Mechanics, using Natural Gas as the example (c) Gary R. Evans. May be used for non-profit educational purposes only without permission of the author. Forward contracts... Forward contracts are custom contracts that stipulate that a given quantity of some commodity (or similar) will be delivered in the future at a price agreed to today, sometimes with complicated clauses, variable pricing schedules (e.g. adjustments for general inflation), incident triggers and the like. The power purchase agreements that are so common in the complicated electricity industry have been essential to the development of renewal energy no lender will cover the high cost of building large-scale wind or solar projects unless the owner of the power plant has a long-term forward contract (PPA) with a utility promising to buy most or all production at a current (typically high) h) price per KwH. These prices are adjustable for externalities and are highly complicated. A futures contract is, to some extent, a liquid, tradable, standardized forward contract with all terms simplified and transparent. 1

2 Web sites Intercontinental Exchange (owns NYME): CMEGroup (CME and CBOT): com Ino (good free site for checking prices): Kitco (metals, including gold): OpenECry (online futures broker): Foreign exchange spot prices: FOREX trading directly (trial account): forex.com or fxcm.com Peruse the CMEGroup site before the next lecture and see what information they provide. Look at the list of commodities they trade and look at their contract specifications and prices. Key terms Spot price: Today's cash price. Futures price: Today's price of a specified futures contract, like Mar 2014 CMEGroup Henry Hub nat gas contract. Expected future spot price: Exactly what the name implies. There is a theory that says that this price will not be the same as the futures price. Volume (futures): The number of contracts traded today (or in any period of time) Open interest (futures): The number of contracts that are "open," that exist right now, that have a long and short position. e-mini contract: A smaller contract in some commodity, usually about half the size, electronically traded. 2

3 What I expect you to know going in... If in doubt, go the the Economics 104 material page at evans/e104ls.htm and read Chapter 10, Futures Contracts, including the appendices, and consider looking at Lecture 12, Introduction to Futures. Additionally, 1. How settlement t works exactly how it works!! 2. How cash/margin accounts are impacted by settlement. 3. How delivery works for physical contracts and what prices are paid. 4. The connection between delta, inversed and leveraged ETPs and futures. Example: CMEG Henry Hub Natural Gas Futures (NG) Trading hours (Globex): 24/7 except 5:15-6:00 PM ET, Friday 5:15 PM Sunday 6:00 PM Mar 2014 contract, weekly data Source: CMEGroup.com Pricing quotation: $ per mmbtu [million British Thermal Units] Contract size: 10,000 mmbtu (current value about $52,000) Initial margin: $5,005 e-mini $1,251 [February, 2014] Maintenance margin: $4,550 e-mini $1,137 Contract price sensitivity: $100 per penny move Final trade day: (typically) 3 business days prior to first day of contract month Delivery allowed?: Yes, complicated, only trading companies can do it. This hit record volume on the day this slide was created. 3

4 Performance Bonds (margins) Unlike when you buy an option, when you enter into a futures contract you are not buying anything and you don t pay for anything. You have entered a contract that either (1) gives you the right to buy something in the future (traditional futures contract) or (2) or gives you a capital gain or capital loss as though you have the right to buy something in the future (modern futures contract with no delivery allowed). The trader has a cash account that is used to meet performance bonds, also called margin requirements, on all futures contracts. It is identical to a cash account in a stock trading account. Each futures contract held by the trader, long or short, has an initial margin and a maintenance margin (also called a day margin). ) The initial margin defines the minimum amount of cash that must be remaining in the account when a new futures contract is undertaken. The cash balance in the account may not drop below the sum total of all maintenance margins, otherwise there is a margin call. Settlement Each day at 2:30 PM ET the cash account referred to in the previous slide is adjusted in the process called settlement. For the front month futures contract the settlement price is calculated by taking the Volume Weighted Average Price (VWAP) for all trades in the two minutes before 2:30 PM. For the second month, contract trade must first meet a minimum volume threshold (50 contracts for NG), then the settlement price is calculated at the VWAP of the spread between the front month base value and second month value. For later months, a related, complicated, but understandable weighted VWAP formula is applied. As of early 2014, this daily settlement procedure was used for WTI Crude, Natural Gas, Heating Oil, and RBOB gasoline. Expiring contract settlement is similar to daily settlement except the VWAP is calculated for the period between 2:00 and 2:30 (half and hour instead of two minutes),with potential complications. For more, see the pdf settlement procedures downloaded from the cmegroup.com 4

5 An example of cash account adjustment March Natural Gas futures contract, long 10,000 mmbtus Natural Gas (NG) daily settlment Day Pi Price Position Gain Cash , , , , , , , , , , , , , ,200 Net gain: 4,200 For a short contract, the signs in the Gain would simply reverse. Contract price sensitivity: $100 per penny. Example In February, you buy a March NG natural gas futures contract for $4.80 per mmbtu (nominal value $48,000). You are long. You want to take delivery. Spot price on the day you enter this contract is $4.84 (not relevant to settlement nor to this contract). When March delivery arrives, spot price has risen to $5.22. Question: What are the settlement terms? You take delivery of the nat gas in March at the new spot ($5.22), not $4.90, so you pay $52,200. You have gained $4,200 in your cash (margin) account. Thetotal cost of this contract to you is ($52,200 4,200) = $48,000 exactly as you intended. The only asset you have is the cash balance of your margin account! 5

6 Exiting the contract (offset) Less than 1% of all futures contracts end with delivery of the commodity! Nearly all traders reverse their trades (called "offset") before the contract expiration date. Remember that the futures price must converge to the spot price as the expiration date approaches. Open interest declines until it is zero. Generally long positions exit at about the same pace as short positions, so open interest is gradually cleared off by the exchange. Remember, you did not "buy" or pay for anything when you opened the contract. You agreed to daily settlement terms, which have been satisfied daily. When you offset you do not sell anything or get paid. You just tinform your broker that tyou are closing out your trade and the exchange says goodbye. Most ICE contracts allow either futures swaps (EFP) or cash settlement instead of delivery even if you do not offset. Many contracts are cash settlement only. Many non-commodity contracts do not have deliverables so offset is automatic. Pricing fundamentals of tangible, storable commodities (like oil and nat gas) The prices of tangible, storable commodities like crude oil, natural gas, wheat, copper, and so forth are fundamentally determined by global trends in supply (production), demand (consumption), and stored inventory, which acts as a buffer between supply and demand. Often futures prices, which have a short-run orientation (although they are influenced by longrun expectations) are strongly affected by unexpected inventory fluctuations. Supply Inventory... and Long run vs. Short run!!! Demand 6

7 NG Spot has been Volatile 1997 to now, monthly data Spot Dec Dec 2012 Inventory glut Katrina Dec 2010 Mar 2011 Jun 2011 Sep 2011 Dec 2011 Mar 2012 Jun 2012 Sep 2012 Dec 2012 We saw gas below $2.00 in April Jan 1997 Jul 1997 Jan 1998 Jul 1998 Jan 1999 Jul 1999 Jan 2000 Jul 2000 Jan 2001 Jul 2001 Jan 2002 Jul 2002 Jan 2003 Jul 2003 Jan 2004 Jul 2004 Jan 2005 Jul 2005 Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008 Jan 2009 Jul 2009 Jan 2010 Jul 2010 Jan 2011 Jul 2011 Jan 2012 Jul 2012 Jan 2013 Jul 2013 Source: Energy Information Administration Natural Gas long-term supply surge: Generally this is thought to have a slight deflationary effect upon spot natural gas prices, but prices have to remain high enough to cover higher extraction costs. Source: Annual Energy Outlook 2013 (early release draft) with Projections to 2040, Energy Information Administration, U.S. Department of Energy. 7

8 ... but the long-term demand picture is complicated by this! Source: Energy Information Administration Annual Energy Outlook Early Release Overview (published early 2014) Storable Commodity Supply and Demand Inelastic when... s Q P X 1 P Q In the modern era, the global supply curve for key commodities can be sticky and inelastic.... but as other economies flex their growth muscles, demand can be fickle and robust! P e e Q e 8

9 Footnote: A classical example in oil... Severe Supply Inelasticity of Oil Global Oil Market Demand Price , , , , , , Daily m illions barrels Source: EIA D D ,000 78,000 80,000 82,000 84,000 86,000 WEFA study commissioned by the American Petroleum Institute in 1990 concluded that the supply elasticity of oil was only 0.13! (controversial) Data source: Energy Information Agency. Storable Commodity Supply and Demand In the modern era, the global supply curve for key commodities can be sticky and inelastic. P 2... but as other economies flex their growth muscles, demand can be fickle and robust! P e e... so as demand increases quickly and unexpectedly, prices, including futures, soar, and inventories deplete (e to 2) Q e Q 2 9

10 An example where inventory matters... Billions of cubic feet 4,000 3,500 3,000 2,500 2,000 1, , Natural Gas Underground Working Gas Inventories Weekly data, December 1993 to August 2009 Working gas equals total gas inventory less base gas, which is required to maintain pressure in underground gas storage. Source: Energy Information Administration 12/31/93 4/30/94 8/31/94 12/31/94 4/30/95 8/31/95 12/31/95 4/30/96 8/31/96 12/31/96 4/30/97 8/31/97 12/31/97 4/30/98 8/31/98 12/31/98 4/30/99 8/31/99 12/31/99 4/30/00 8/31/00 12/31/00 4/30/01 8/31/01 12/31/01 4/30/02 8/31/02 12/31/02 4/30/03 8/31/03 12/31/03 4/30/04 8/31/04 12/31/04 4/30/05 8/31/05 12/31/05 4/30/06 8/31/06 12/31/06 4/30/07 8/31/07 12/31/07 4/30/08 8/31/08 12/31/08 4/30/09 4,000 Working Underground Gas Inventories for a Typical Year: ,500 3,000 Here the seasonal feature is obvious... Winter draw-down for heating. 2,500 2, ,500 Summer build-up from production less electricity demand 1, /4/08 2/1/08 2/29/08 3/28/08 4/25/08 5/23/08 6/20/08 7/18/08 8/15/08 9/12/08 10/10/08 11/7/08 12/5/08 10

11 2014:... massive inventory drawdown due to record-setting cold weather The polar vortex in early January ypushed temperatures in the East to record lows which in turn caused a huge drawdown in seasonal natural gas inventories. Jan 20, 14 Nat gas is in backwardation... How to play it?? A14S to A15L spread? Feb 5, AA: MA: AA: MA: A narrow spread bet would be losing

12 Background on Nat Gas 2012 contango This inventory situation implies low prices. Because of the success of shale gas drilling (not shown) and because we are having one of the warmest winters on record (see heat map) underground inventory is full there is no storage available for gas, which is why it can t be arbitraged. There is a massive supply glut Example: Spreading the Nat Gas contango of 2012 What we noticed at 0.06 the start of 4.00 class Mar July Nov Mar July Nov Mar July Nov Mar Price Monthly CGR 12

13 A quick futures spread... Settlement Calculation Natural Gas Spread of January 25, 2012 CMEGroup Henry Hub (HH) Mar 2012 long, Mar 2013 short March 2012 (L) March 2013 (S) Settlement delta long Settlement delta short Notional value Day Date W 1/25/ ,700 T 1/26/ , ,370 F 1/27/ ,390 M 1/30/ ,370 T 1/31/ ,460 W 2/1/ ,100 1,250 62,610 F 2/3/ ,400 61,170 M 2/6/ ,900 T 2/7/ ,200 61,320 W 2/8/ ,260 F 2/10/ ,600 We went long on the nearest term contract (March 2012) and shorted a contract one year later, knowing that gas has a one-year cycle, 13

(c) 2006-2014 Gary R. Evans. May be used for non-profit educational purposes only without permission of the author.

(c) 2006-2014 Gary R. Evans. May be used for non-profit educational purposes only without permission of the author. The futures markets Introduction and Mechanics (c) 2006-2014 Gary R. Evans. May be used for non-profit educational purposes only without permission of the author. Forward contracts... Forward contracts

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