Oil derivatives are financial instruments using oil, usually crude, as an underlying asset. The derivative has no inherent value and is only a contract for an oil-related activity, but people can trade, sell, and buy derivatives to access the value of the oil used as the basis of the contract. Such contracts have been a part of financial markets since the 1800s and provide producers of various products with a number of useful tools for conducting business. Companies can use oil derivatives to distribute and reduce risk, as well as to address issues like not wanting to store oil for extended periods of time.
The most basic oil derivative is a futures contract. When people prepare the contract, one party agrees to buy a set amount of oil at a given price on a date in the future. Another form is an options contract, where people have the option to make a purchase on a particular date, and they can then decide whether they want to exercise it. Oil derivatives allow people to manage risk; for example, a futures contract can help people avoid temporary volatility in oil pricing and get oil at a guaranteed price. Options can provide for hedging, creating an opportunity to buy below market price or sell above it, depending on the structure of the contract.
While oil derivatives were initially developed for use by the oil industry, other investors can trade them. In many cases, people trading derivatives have no plans for taking delivery of the underlying asset; a Wall Street investor has absolutely no interest in a tanker ship worth of oil, but does want to take advantage of shifts in oil prices to profit on oil derivatives. These contracts provide a mechanism for investing in commodities trading. People can also buy and sell stocks and bonds issued by oil companies.
Trading oil derivatives requires knowledge of the industry, skill, and the ability to make savvy market projections. People rely on numerous kinds of data to make investment decisions. The news can provide insights into potential future changes in oil prices, and people also pay attention to political developments, oil policy, and issues like consumer demand. Knowing, for example, that demand for oil tends to rise in the summer, people can plan their investment activities accordingly.
Derivatives trading is usually the purview of advanced investors or special funds. It can be risky, especially in large volumes and on a volatile market. Even skilled investors may make mistakes when it comes to predicting future financial moves, and this can translate into costly losses.