Forward Oil Markets: Futures and Swaps

Paper Barrels and Wet Barrels

The spot or cash price is the price of oil for immediate delivery. A forward price is the price for delivery at a specified date in the future. Oil for future delivery is most commonly traded using exchange-traded futures contracts and over-the-counter (OTC) swap contracts. If you choose, you never have to take or make delivery of physical oil. Because you do not touch the physical market, these are called paper barrels, as opposed to wet barrels. Paper barrels are also called derivative instruments because their value is derived from physical oil prices without necessarily resulting in ownership of physical oil.

In certain circumstances, such as holding a futures contract past its expiry date, you can take or make delivery of physical oil. This link anchors paper contracts to real prices. Fewer than 1% of paper contracts convert into physical oil, but that thin thread of convergence is what keeps paper from drifting into pure abstraction. When the tether snaps, as it did at Cushing in April 2020, prices can do extraordinary things.

The Forward Curve and Its Two Shapes

Plotting forward prices across delivery dates creates a forward curve, also called a forward strip or term structure. Each benchmark grade of oil has its own forward curve. The parts of the curve closest to expiry are the front end; the parts farthest out are the back end. The price difference between one month and the next is an intermonth spread or switch. The difference between the front and the back is a time spread.

Forward curves are either in contango (upward sloping, farther-out months above spot) or in backwardation (downward sloping, spot above farther-out months). Contango signals too much oil today relative to today's demand, and implies money to be made by buying spot, storing, and selling forward. Backwardation signals a relative shortage today and discourages storage by offering a better price now than in the future. Oil forward curves flip between the two shapes as physical conditions change.

Cost of Carry and Full Carry

Contango intermonth spreads are bounded by the cost of storing and financing oil. Add the monthly tank rental, the financing charge on the barrels you have bought, and the insurance, and you get the cost of carry. When the intermonth spread in contango equals the monthly cost of carry, the market is said to be at full carry. Any wider and a storage trader can lock in a riskless profit by buying spot, selling forward, and renting tanks. The arbitrage flattens the curve back toward full carry.

Backwardation has no such constraint: there is no mechanism to arbitrage a backwardated curve back to flat. You cannot borrow a barrel from the future and deliver it today. That asymmetry is why Keynes, in his 1930 Treatise on Money, called backwardation the normal state of commodity markets and coined the phrase "normal backwardation." He argued that producers hedge more than consumers and therefore must pay a premium to transfer price risk to speculators. In oil, the deeper reason backwardation dominates is structural: contango can always be traded away by building new storage, but backwardation cannot.

April 20, 2020: The Day Oil Went Negative

Marginal Finding and Development Cost at the Back of the Curve

The very back end of the oil forward curve is, in principle, the market's estimate of the finding and development cost of marginal crude barrels. If you raised capital today, explored, developed the field, and brought production to market, what price would justify the investment? Anything you can lock in beyond the five-year tenor of the curve is a rough vote on that number. In the 1990s the long-term back-of-curve price sat around $20 per barrel when conventional onshore fields were the marginal source. Since 2003 it has pushed up as marginal barrels moved toward deep offshore, oil sands, and tight oil. Back-of-curve prices are not forecasts: historically they have been poor predictors of actual spot prices over the same horizon. But they are still the best real-money signal available for long-term marginal production cost.

Spreads: How Oil Traders Actually Trade

Oil traders distinguish between flat-price (outright directional) positions and spread positions. A flat-price position is exposed to absolute up-or-down price movement. A spread position is exposed to the price difference between two things: two grades of oil, the same grade of oil in two locations, the same grade of oil in two delivery periods, or a product against its crude feedstock. The market risk of a spread is called basis risk.

Spreads are usually quoted as positive numbers, the higher price minus the lower. If you buy a positive spread, your position gains when the spread widens. If you sell a positive spread, your position gains when the spread narrows. Four common spread families dominate oil trading:

• Crack spreads (refinery margin): refined product prices minus crude oil prices, the margin a refinery earns for turning crude into fuels.
• Arbitrage spreads (arbs): the same or closely related oil priced in two regions. Arbs are primarily a function of transport rates between the two. The most famous is the WTI-Brent Atlantic arb.
• Relative value spreads (diffs): two different but closely related products in the same region, such as naphtha versus gasoline in Rotterdam, or high-sulphur versus low-sulphur diesel in the US Gulf. A regrade is a relative value spread between different grades of the same product.
• Time spreads (calendar spreads): the same grade of oil across two delivery periods. Used to trade seasonality, storage economics, and the general shape of the curve.

The 3:2:1 and 2:1:1 Crack Spreads

The US refining industry lives and dies on the crack spread. The standard benchmark is the 3:2:1: three barrels of crude in, two barrels of gasoline out, one barrel of distillate (heating oil or diesel) out. The ratio roughly reflects the yield profile of a typical US Gulf Coast refinery running a medium crude. A refinery that sells the 3:2:1 spread forward has locked in both sides of its margin in a single trade: it has effectively bought crude and sold products at a fixed gross margin. The 2:1:1 spread (two crude, one gasoline, one distillate) is preferred for refineries whose yields lean heavier toward distillate, typically those running heavier crudes with more hydrocracker and coker capacity.

Neither crack spread exactly represents any real refinery. Actual refineries have more complex slates (LPG, jet, petchem feedstocks, coke, asphalt), pay different crude diffs by grade and location, and carry energy and utility costs the simple spread ignores. But the 3:2:1 is the most widely quoted refining margin number, and it is what refinery hedgers trade when they want to lock in a margin without negotiating every barrel of every product independently.

The Spreads Family Tree

Benchmark grades of oil around the world are linked into a family tree by traded spreads. Light sweet crudes trade against each other, heavy crudes against lighter ones, regional benchmarks against global references. A trader arbitraging Midland WTI against Cushing is walking along one branch; a trader arbitraging Dated Brent against BFOET is walking along another. The diagram below shows the main families.

Exchange-Traded Futures

A futures contract gives you the right to buy or sell a standardized quantity of oil for delivery at a specified date in the future. Buying futures is called going long: the trade makes money if prices rise. Selling futures is called going short: the trade makes money if prices fall. Adding an offsetting trade in the opposite direction is called unwinding or closing out. A position that has been completely offset is said to be squared out.

Margin and the Clearinghouse

To trade futures you open an account with a broker and post an initial cash margin deposit. The broker passes that deposit to a central clearinghouse, which manages the credit of the entire exchange. The clearinghouse becomes the counterparty to every trade: buyers face the clearinghouse, sellers face the clearinghouse, and no individual trader has direct credit exposure to any other. This mutualization of credit is the single biggest structural difference between futures and OTC.

If the market moves against you, the clearinghouse issues a variation margin call, requiring you to post additional cash to cover the loss. Variation margin is collected daily, at the end of each trading session, based on the exchange's settlement price. The process is called mark-to-market: every position is revalued to the day's close and unrealized losses are converted into realized cash movements. If you fail to post variation margin, the clearinghouse closes your position and uses your initial margin to cover any residual loss.

Initial margin of 5 to 10% of contract value means a trader can control $70,000 of oil exposure for about $5,000 in margin, roughly 14-to-1 leverage. Small price moves then create large profits or losses relative to margin posted. This leverage is why futures are viewed with fear by the general public. Traders who cannot absorb a margin call through a short adverse move are called weak hands and are regularly stopped out of positions that later move back in their favor. A trader who posts the full notional value as collateral, with the broker or in a bank account ready for margin calls, is called a strong hand and is fully collateralized. Weak hands provide the liquidity; strong hands collect it.

Worked Example: Five-Day Mark-to-Market

The table below walks through a five-day mark-to-market cycle for a trader who buys 10 WTI contracts (10,000 barrels) at $80.00 per barrel on Day 1 and holds the position through settlement each day. Each $1 move per barrel creates a $10,000 gain or loss across the 10 contracts.

On Day 3, the trader faced a $40,000 margin call on a $50,000 initial deposit. A weak hand unable to post would have been closed out at $78 and locked in a $20,000 loss. A strong hand who posted the call went on to recover to +$10,000 by Day 5. This is the daily cash discipline that separates futures from a buy-and-hold investment: you must be able to survive the path, not just the destination.

The Five Liquid Oil Futures Contracts

Globally, only five oil futures contracts carry meaningful liquidity. Three are listed in New York and two in London. Every other exchange contract is either niche, regional, or effectively a wrapper around one of these five.

One metric tonne of gasoil is roughly 7.45 barrels. One 42,000-gallon gasoline or distillate contract is exactly 1,000 barrels, matching the WTI and Brent size so that crack spreads can be constructed one-for-one with a single contract on each leg. That design choice is not an accident: it is what makes the 1:1:1, 3:2:1, and 2:1:1 crack spreads executable as single-click trades on an exchange screen.

Futures Ticker Format

The month codes look arbitrary because they are relics of the open outcry era. On a noisy trading floor where hundreds of traders were shouting bids and offers and flashing hand signals across a crowded pit, the letters had to be legible at a distance and impossible to confuse with numbers or with each other. That ruled out A, B, C, D, E, I, L, O, P, R, S, T, W, and Y. What remained was the odd-looking sequence F, G, H, J, K, M, N, Q, U, V, X, Z. The pits are almost all gone now, but the codes they invented still stamp every oil futures ticker on every screen in the world.

The front-month contract (the one closest to expiry) is also called the first nearby or prompt contract. The next one out is the second nearby. Contracts one, two, and three December months forward are sometimes called red, blue, and green December, a Eurodollar-desk shorthand that bled into oil in the 1990s.

Over-the-Counter (OTC) Swap Contracts

An OTC contract is similar to a futures contract: you buy and sell oil exposure for dates in the future. The differences are that OTC contracts are customizable, traded bilaterally rather than on an exchange, and almost always cash settled. The OTC market caters to large organizations rather than individuals. The International Swaps and Derivatives Association (ISDA) produces the standardized legal templates the market runs on. A typical trade confirmation is three or four pages of ISDA-style language.

The word swap captures the economics: the transaction allows oil price movement risk to be swapped from one trader to another. An airline buying a jet fuel swap is paying fixed and receiving floating, or going long a swap. An oil producer selling a crude swap is receiving fixed and paying floating, or going short a swap. Most OTC swaps settle against the monthly average of daily benchmark prices, a structure called Asian settlement or average-rate settlement. A swap that settles against a single day is a bullet swap.

A Worked Airline Swap: The Book's Signature Example

On January 10, Trader A at an airline phones Trader B at a bank. Trader A is worried about a military buildup on the border of two major oil producers and thinks jet fuel prices could rally hard in March. Trader A wants to buy 20,000 metric tonnes of Platts NWE jet fuel for the month of March. Trader B offers a fixed price of $1,510 per metric tonne. They trade at that level.

During March, the swap prices out each business day against the Platts North-West Europe jet fuel settlement. At the end of the month, the final floating leg is the simple average of those twenty business-day prints. Suppose the average comes in at $1,550.25 per metric tonne. Here are the two cash flows:

Payments are netted, so no one wires $30 million. The back offices calculate the difference and the losing side wires a single net number, in this case $805,000, on the fifth business day after month end. The airline has achieved exactly what it wanted: an effective purchase of March jet fuel at $1,510 per metric tonne, regardless of where the actual market went. If the average had printed below $1,510, the airline would have paid the bank the difference and walked away with a fixed price that was, in hindsight, worse than the floating market. That regret-in-hindsight outcome is the cost of hedging, and it is the part that airline CFOs have to defend to their boards every year.

Where Futures and Swaps Differ

EFP, EFS, and Block Trades

Three mechanisms bridge the exchange and OTC worlds. An Exchange for Physical (EFP) is a privately negotiated swap of a futures position against a matching physical position: two counterparties agree on a price, one side ends up with wet barrels, the other with the futures exposure, and the trade is reported to the exchange without touching the order book. An Exchange for Swaps (EFS) does the same thing between futures and an OTC swap. A block trade is a large order negotiated off-screen and then reported to the exchange, subject to minimum size thresholds. All three exist so wholesale participants can move institutional-size risk without the slippage a screen order would impose.

The Live Curve Today

The curve above is live WTI. Look at whether the first two months are in contango or backwardation, and by how much. That front-end shape is the most sensitive real-time indicator of physical tightness at Cushing, and it is the first number every crude trader checks in the morning.