Energy futures are standardized financial contracts that allow buyers and sellers to trade specific quantities of energy commodities. These contracts provide a way for producers, consumers, and traders to hedge against price volatility in the energy markets or to speculate on future price movements.

In this article, we will explore energy futures, such as crude oil and natural gas, in detail and learn how they’re traded on major exchanges. We will also study some major factors influencing energy prices, such as supply and demand dynamics, seasonal trends, and government policies.

As you read further, you will learn various trading strategies, like trend following, spread trading, and arbitrage opportunities. Lastly, we will explain some proven risk management techniques like setting stop-loss orders, managing leverage, and diversification to help you protect your capital and minimize losses. Let’s get started. 

What are Energy Futures? 

Energy futures are financial contracts that commit the buyer to purchase and the seller to sell:

• A specified quantity of an energy commodity, 
• At an agreed-upon price,
• On a specified future date.

These contracts are standardized and traded on futures exchanges. Energy futures are mostly used to hedge against price volatility in the energy markets. Let’s have a look at some commonly traded energy futures contracts:

1. A) Crude Oil Futures

Crude oil futures are among the most actively traded energy futures contracts. The primary benchmarks are:

• West Texas Intermediate (WTI) Crude Oil Futures

• • The WTI futures contracts are traded on the New York Mercantile Exchange (NYMEX).
  • WTI crude is the main benchmark for oil prices in North America.

• Brent Crude Oil Futures

• • These futures contracts are traded on the Intercontinental Exchange (ICE).
  • Brent crude is the primary global benchmark.
  • It is widely used for pricing oil produced outside North America.

Some common contract specifications:

1. B) Natural Gas Futures

Natural gas futures are traded primarily on the NYMEX. The most traded natural gas contract is the Henry Hub Natural Gas Futures. Its contract specifications are as follows:

• Each contract represents 10,000 million British thermal units (mmBtu) of natural gas.
• U.S. dollars per mmBtu: This is how the prices for these contracts are quoted.
• The Henry Hub in Louisiana serves as the pricing point for these contracts.
• This hub precisely reflects the supply and demand conditions in the U.S. natural gas market.

1. C) Renewable Energy Futures

Renewable energy futures are emerging as a new market segment due to a rapid shift towards cleaner energy sources. These contracts are still developing but are gaining traction. Let’s have a look at some common types of renewable energy futures:

Key Features of Energy Futures Contracts 

Like every other type of futures contract, energy futures have several standardized specifications to facilitate trading and ensure market liquidity. Listed below are some of their key specifications:

• Contract size,
• Pricing unit, and
• Contract months.

Let’s study these key specifications for various energy futures:

1. I) Contract Size

• Crude Oil

• • WTI Crude Oil Futures: Each contract represents 1,000 barrels of crude oil.
  • Brent Crude Oil Futures: Each contract also represents 1,000 barrels of crude oil.

• Natural Gas Futures

• • Henry Hub Natural Gas Futures: Each contract represents 10,000 million British thermal units (mmBtu) of natural gas.

• Renewable Energy Futures

• • Carbon Emission Allowance Futures: The contract size varies but often represents 1,000 tonnes of CO2 allowances.
  • Renewable Energy Certificates (RECs) Futures: Usually, each contract represents a standardized quantity of RECs, such as 1,000 MWh.

1. II) Pricing Unit

• Crude Oil Futures: Prices are quoted in U.S. dollars per barrel.
• Natural Gas Futures: Prices are quoted in U.S. dollars per mmBtu.
• Carbon Emission Allowance Futures: Prices are quoted in euros or U.S. dollars per tonne of CO2 equivalent.
• Renewable Energy Certificates Futures: Prices are quoted in U.S. dollars per REC.

III) Contract Months

It is pertinent to note that energy futures contracts are available for trading in several contract months throughout the year. This kind of availability allows participants to choose the delivery month that best suits their hedging or trading needs.

Major Global Exchanges for Energy Futures Trading

Several exchanges provide a platform for energy futures trading. They allow participants to:

• Manage risk,
• Speculate on price movements, and
• Ensure price discovery in the global energy markets.

Let’s have a look at some major exchanges and the types of futures contracts traded on them:

Factors Influencing Energy Futures Prices

Traders must note that the prices of energy futures contracts are influenced by several factors, such as:

• Global supply and demand,
• Seasonal consumption patterns,
• Geopolitical events,
• Economic indicators, and
• Government policies.

Understanding these factors is crucial as it helps manage risks and optimize trading outcomes. Read the detailed explanation of these factors provided below:

Factor I: Global Supply and Demand

Factor II: Seasonal Consumption Patterns

The consumption and prices of energy also experience seasonal variations due to changes in:

• Weather 

and

• Daylight hours.

Let’s understand this price fluctuation in different seasons:

Factor III: Government Policies and Environmental Regulations

Government actions and regulations shape the energy markets. That holds even more as the world gradually transitions towards renewable energy sources. Let’s see how this factor impacts the energy prices:

• Emissions Standard

• • • Stricter emissions standards increase costs for fossil fuel producers.
    • This reduces supply and raises prices.

• Subsidies and Incentives

• • • Government incentives for renewable energy (e.g., solar, wind) boost investment in these sectors.
    • This again impacts the demand for traditional energy sources.

• Carbon Pricing

• • • Implementing carbon taxes or cap-and-trade systems increases the cost of emitting carbon dioxide.
    • This implementation encourages a shift away from fossil fuels, which impacts energy futures tied to oil and gas.

• Tariffs and Trade Agreements

• • Import tariffs on energy commodities affect prices by:
    • Altering supply chains 

and

• Increasing costs.

• Conversely, trade agreements that facilitate energy exports boost supply and impact global prices. 

Trading Strategies for Energy Futures 

Trading strategies for energy futures involves several techniques. Most of them focus on:

• Capitalizing on price movements

and

• Managing risks.

These strategies range from hedging against price volatility to speculative trading based on market analysis, seasonal trends, and more. Let’s study the 4 most commonly used strategies:

Strategy I: Trend Following 

The trend following involves identifying and capitalizing on sustained directional movements in energy prices like crude oil or natural gas. This strategy relies on technical analysis (say moving averages). Using it, traders determine the following:

• The direction of the trend’s strength 

and

• Strength of the trend.

Let’s see how you can implement the trend-following strategy:

Step I: Identify the Trend using Moving Averages (MAs)

Moving averages smooth out price data to help identify the direction of the trend. You can prefer using the following MAs:

Step II: Determining the Trend’s Strength and Direction

• Bullish Trend

• • A strong upward trend is confirmed when:
    • The 10-MA is above the 50-MA 

and 

• The price is also above both moving averages.

• Bearish Trend

• • A strong downward trend is confirmed when:
    • The 10-MA is below the 50-MA 

and

• The price is below both moving averages.

Step III: Entry and Exit Points

• Entry Points in a Bullish Market

• • • Monitor for the price to retrace towards the 10-MA during an upward trend.
    • When the price bounces off the 10-MA and starts to rise again, it could be an entry point.

• Exit Points

• • Set a stop-loss order slightly below the 50-MA.
  • This will help you limit potential losses if the trend reverses.
  • You can set profit targets based on previous resistance levels or a fixed risk-reward ratio.

Now, let’s use an example to understand better:

Scenario of the Market: Crude Oil Futures

• The price has been consistently above the 50-day moving average, indicating a bullish trend.
• The price retraces towards the 10-day moving average.

Identify the Trend

• Check if the crude oil price is above the 50-MA (bullish trend confirmation).
• Ensure the 10-MA is also above the 50-MA for trend strength.

Monitor Retracements

• Wait for the crude oil price to pull back towards the 10-MA.

Enter the Trade

• Enter a long position when:
  • The price bounces off the 10-MA 

and

• Starts to move upward again.

Set Stop-Loss and Profit Targets

• Set a stop-loss order just below the 50-day moving average.
• This placement helps you protect against a trend reversal.
• Set profit targets based on:
  • Previous highs 

or 

• Predefined risk-reward ratio.

An Example Trade

Strategy II: Hedging

It is common for traders to hedge using energy futures contracts. It allows energy producers and consumers to protect themselves against price volatility. By locking in prices for future delivery, they can reduce the impact of market fluctuations by stabilizing:

• Costs

and

• Revenues.

How Energy Producers and Consumers Use Futures for Hedging?

Example of Hedging Exercised by an Energy Consumer – Airline Company

Scenario

• Assume that an airline company anticipates needing 100,000 barrels of jet fuel in the next six months.
• The current price of crude oil is $70 per barrel.
• The airline is concerned about potential price increases and decides to hedge using energy futures.

Determine Hedge Size

• • The airline hedges its fuel cost by purchasing oil futures contracts

• Since each crude oil futures contract represents 1,000 barrels, the airline buys 100 futures contracts at $70 per barrel.

Hedge Implementation

• The airline locks in the price at $70 per barrel by entering into these futures contracts.

Outcome

Strategy III: Spread Trading

Spread trading involves speculating on the price difference between two related futures contracts rather than their outright price movements. Traders seek to profit from shifts in the relative value of these contracts.

Let’s understand through a hypothetical example related to “Oil Futures Spread Trading”

Technique Used – Intra-market Spread

• This involves the same commodity but different contract months.
• For example, 
  • Buying in July oil futures contracts

and

• Selling September oil futures contracts.

Strategy

• During the summer, demand for oil usually increases due to higher gasoline consumption.
• A trader decides to:
  • Buy July futures (expecting prices to rise due to increased demand) 

and

• Sell September futures (anticipating that prices will stabilize or fall after the peak season).

  Execution

• Buy July Futures: Enter a long position in July oil futures.
• Sell September Futures: Enter a short position in September oil futures.

Objective –  Profit from Spread Widening

• If the price of July futures rises relative to September futures, the spread widens.

• This allows the trader to profit from the difference.

Strategy IV: Arbitrage

Arbitrage involves exploiting price discrepancies between similar energy products or different markets to earn risk-free profits. However, arbitrage opportunities require quick action and precise execution.  

Let’s understand this strategy using an example related to “Natural Gas Arbitrage”.

Scenario

• Natural gas trades at a discount in one market compared to another.
• This price discrepancy is due to some temporary logistical issues.

Strategy

Objective – Profit from Convergence

• As logistical issues are resolved, prices converge.

• This convergence allows traders to profit from the price difference.

How Important Are Risk Management Techniques in Energy Futures Trading?

Effective risk management is crucial. It mitigates potential losses and ensures long-term profitability. Some key techniques to manage risks are as follows:

• Setting stop-loss orders,
• Managing leverage,
• Diversification,
• Daily risk limits, and
• Periodic reviews.

Let’s understand these risk management techniques in detail:

• Setting Stop-Loss Orders

• • These orders help mitigate losses by automatically closing a position once it reaches a specified price threshold.
  • For example: 
    • Say a trader buys crude oil futures at $70 per barrel.
    • They set a stop-loss order at $65 per barrel.
    • If the price falls to $65, the position is automatically sold.
    • Therefore, the loss is capped only at $5 per barrel.

• Managing Leverage

• • It helps control the amount of borrowed funds used in trading to amplify returns.
  • It is always advisable to use leverage conservatively to avoid large losses.
  • For example,
    • Say a trader has $10,000.
    • They use 2:1 leverage.
    • This means they are controlling $20,000 worth of futures.
    • Assume the trader switches to 9:1 (excessive leverage).
    • This means that the trader now controls $90,000 worth of futures with their own $10,000.
    • This leads to significant losses if the market moves unfavorably.

• Diversification

• • This technique helps in spreading risk across different assets or markets to reduce exposure to any single risk.
  • For example,
    • Instead of concentrating all capital in crude oil futures, a trader also invests in:
      • Natural gas futures,
      • Electricity futures, and
      • Carbon emission futures.
    • This way, adverse price movements in one market can be offset by gains in another.

• Daily Risk Limits

• • By setting daily risk limits, traders can cap the maximum loss they incur in a single day.
  • For example,
    • Say a trader sets a daily loss limit of 2% of $100,000.
    • This means once losses reach $2,000 in a day, all trading activities are halted to prevent further losses.

• Periodic Reviews

• • This strategy involves regularly assessing:
    • Trading strategies,
    • Risk exposures, and
    • Market conditions.
  • For example
    • Say a trader conducts weekly or monthly reviews of all:
      • Positions,
      • Risk metrics, and
      • Performance.
    • They adjust strategies based on the latest market analysis.
    • Also, they review compliance with risk management policies.

Conclusion

Energy futures are essential tools for managing price risk and capitalizing on market opportunities. They allow producers and consumers to hedge by “locking in prices” and traders to “speculate on price movements”. Notably, crude oil and natural gas are the most traded energy futures contracts, with emerging markets in renewable energy futures also gaining attention. Some key features of these contracts include their standardized size, pricing units, and the variety of contract months available for trading. Some major exchanges like NYMEX and ICE facilitate these trades.

To trade effectively, traders must understand the factors influencing energy futures prices, such as global supply and demand, seasonal consumption patterns, and government policies. Some proven energy futures trading strategies include trend following, which uses moving averages to identify price directions; and spread trading, which exploits price differences between related contracts. 

Furthermore, risk management is vital as it protects capital losses and avoids margin calls. It can be done using several techniques, such as setting stop-loss orders, managing leverage, and diversification. Risk controls can also be implemented, such as setting daily risk limits and performing periodic reviews. 

Do you wish to explore more about day trading futures, strategies, risks, and rewards? Read this article now and build your knowledge base!