Why futures contracts hold key to stable oil prices

There is a crisis building up in the Middle East that can dampen economic growth prospects in oil importing countries.

We are however not taking note of tension between the US and Iran, and this might be costly to our economy.

 Kenneth Walsh in 2002 gave advice to nations in asset markets, such as that for oil: “Buy when you hear the sound of the canon; sell when you hear sound of the bells.”

On the sound of a canon, the asset might become cheaper because their prices go down or up due to scarcity.

However, the movement in market prices varies from one asset to another.

For some assets, there will be fire sales of assets, assuming the supply is unchanged; and others will be hoarded, leading to increase in prices.

Gold prices are likely to increase during economic crises. The question is, what happens to oil prices when there is a prolonged crisis in the Middle East? Or when there is an attack on Saudi Arabia oil facilities?

For More of This and Other Stories, Grab Your Copy of the Standard Newspaper.

 The attack forced Saudi Arabia to shut down half of its oil operations, translating into 5.7 million barrels per day.  

The result was the largest spike in crude oil prices in the past 19 years.

This required Saudi Arabia to freeze oil exports, thus denying the world five per cent of crude oil.

Prices increased from Sh5,750 ($57.38) per barrel in August 2019 to Sh7,000 ($69.02) on September 16 and eased back to Sh6,500 ($64.40) on September 19.

Red Sea

The question then is, given the activities in Iran and Saudi Arabia, why do oil prices appear to be relatively calm?

In the case of Saudi Arabia, the future oil prices will depend on navy activity on Red Sea in the west and the Persian Gulf in the east.

 The Saudi Arabia naval forces and air cover can protect the oil fields thus ensuring continuous production of oil, but it will be difficult transporting the oil.

 The unfriendly ones will hamper production and distribution of oil.

The costs associated with the activation of naval forces are discounted in the oil prices, pushing the prices up.

 Thus, there will be an increase in oil prices should the political situation in Middle East become unstable.

Like any asset, the oil price is driven by demand and supply.

This is why to stabilise oil prices after Saudi Arabia attack, US President Donald Trump authorised release of oil from strategic petroleum reserve.

 Oil prices stabilise when there is no imbalance between demand and supply.

Maybe President Trump never intended to release the reserve, but it appears his statement calmed the oil markets.

 However, what might have reassured oil prices is a futures contract on oil.

A futures contract is a legal agreement to buy or sell oil at a pre-determined price at a specified time in the future exchange.

The buyer of a futures contract is obliged to buy the oil at an agreed price regardless of the prevailing market price, while the seller of a futures contract is taking on the obligation to provide oil as agreed; thus both sellers and buyers are protected against adverse movement in oil prices.

Futures contract

If both oil producers and consumers use futures contracts, the wild movements in oil prices tend to be less spiky.

With oil futures contracts, there is no need for bulk storage because companies only need to purchase contracts to buy or sell oil.

 It is possible that market players might have anticipated the Middle East crisis and discounted the potential effects in oil prices.

 Those who deal in oil futures incorporate expected political, social and economic changes in asset prices.

Whenever there is a crisis in the Middle East such as the Gulf war in 1990-91 and Operation Desert Storm in 1996, oil futures prices exhibited a rising trend because the demand for oil money abruptly shot up and so the price of oil.

 So what should we expect as tension builds up as predicted by US?

Pentagon said that recent strikes on Saudi Arabian oil facilities were sophisticated and amounted to dramatic escalation in tension within the region.

 It is likely that oil prices worldwide will increase and the quality of lives in oil importing countries negatively impacted on. Are we prepared?

-The writer teaches at the University of Nairobi  

Do not miss out on the latest news. Join the Standard Digital Telegram channel HERE.

Oil CrisisSaudi ArabiaOil PricesFuel Prices