What are Heating Oil Futures?
Heating oil futures are heavily traded in the U.S. and around the world, giving heating oil producers and consumers a valuable financial product to protect themselves against the risk of price fluctuations in the heating oil market.
A heating oil future is a standardized contract, traded on an exchange, where the contract buyer agrees to take delivery of a specific amount of heating oil on a predetermined date at a locked-in price. The seller agrees to make such a delivery adhering to the same contract specifications.
Heating oil prices are often directly associated with WTI crude, and hence are open to fluctuations, which is why traders have come to view heating oil futures as an attractive opportunity to manage risk and make profits.
What is Heating Oil?
Officially known as the No.2 fuel oil, heating oil is a refined byproduct of crude oil that is popular as a fuel used in furnaces or boilers for indoor heating. In the U.S. it is widely used in the Northeastern regions for residential heating. Since it is used primarily for heating during the coldest months of the year—from December to March— heating oil is one of the commodities most affected by seasons.
Heating oil is produced at oil refineries. Crude oil is broken down during the refining process, and separated into various fuels like gasoline, kerosene, diesel, lubricating oil and heating oil. Heating Oil is nearly 25% of the yield of a barrel of crude—the second largest by-product after gasoline. Around 2 gallons of heating oil is produced from a 42 gallon barrel of crude oil.
Heating oil and diesel are closely related products called distillates, but have different properties,
Often red dyes (or solvent yellow dyes in Europe) are added to heating oil to make it easier to identify. In the U.S. the red dye indicates that the product in tax-exempt and is not for highway use.
It is a flammable liquid, classified as a hazardous material and is transported from refineries to oil storage terminals at central distribution areas like the New York Harbor. It is then redistributed to consumer areas by barges, from where tank trucks carry it to retail dealers or residential consumers. Heating oil is usually stored at these end locations in above-ground storage tanks (ASTs).
Brief History of Heating Oil
The use of heating oil came into prominence when the oil burner was invented in 1920s. Heating Oil quickly replaced the then-ubiquitous coal for indoor heating, since coal was expensive, created a mess, and required large storage space. Heating oil was cheaper and easier to handle, while also cutting down pollution—it left no soot or ash.
Over the years, technology has made heating oil use even more efficient, cleaner and safer. Heating oil provides a more even heat, and homeowners can control temperatures simply by touching the thermostat.
Today, there are over 9,000 retail heating oil businesses in the U.S. with sales of over $16 billion. These heating Oil dealers today provide various services to customers to help them extract maximum value from their heating oil—through convenient budget plans and comprehensive service and maintenance.
Where is Heating Oil Produced?
Heating oil is a by product of crude oil. In 2011, 56% of U.S. crude oil came from five states: Texas, Alaska, California, North Dakota and Oklahoma.
This crude oil is processed at many domestic refineries in the U.S., however the production of Heating oil is given a lower priority, after the more in-demand gasoline, so refinement levels of heating oil fluctuate from year to year. If gasoline demand is high, refiners may delay the production of heating oil.
Refineries are also limited in the time they have to make heating oil for winter usage. Some of the heating oil is produced during the summer and fall months and stored as inventory. Additionally, there is a supply ceiling to heating oil, since to produce more heating oil, refiners will also have to produce more of other petroleum products which are usually not in high demand during winters (petrol and diesel are usually in high demand in summers when people travel).
Refineries in the U.S. produce 85% of distillate fuels which includes heating oil and diesel (though the two are separate fuels with differing properties). The U.S. also exports 200 barrels a day on average of distillate fuel while importing around 15% of heating oil from Canada, Russia, the Virgin Islands, and Venezuela.
Internationally, Saudi Arabia is no.1 in producing heating oil, followed by Russia and then the U.S.
According to the International Energy agency, the United States will become the world's largest heating oil producer by 2020 thanks to new technologies. The U.S. heating oil production is expected to increase to 109 million barrels per day in 2015, and to 11.1 million barrels per day by 2020—overtaking Saudi Arabia and Russia as the largest producer. The U.S. is also expected to export more heating oil than imports by 2030, becoming self-sufficient as far as heating oil is concerned.
How is Heating Oil Used?
Heating Oil is used primarily for residential heating and is the most important alternative energy source for homes that don't have access to natural gas for heating.
Heating Oil has a high demand in the Northeastern U.S. due to the cold weather and the high cost or inaccessibility of substitutes like natural gas or propane. Around 8.1 million houses in New England and Central Atlantic regions in the U.S. use heating oil extensively during winters.
The Northeastern U.S. accounts for almost 70% of the consumption of heating oil. In 2010, about 3.3 billion gallons of heating oil were sold to residential consumers in the Northeast; which amounted to 85% of total U.S. residential fuel oil sales.
The top five heating oil consuming states in 2010 were New York, Connecticut, Massachusetts, New Jersey and Philadelphia.
Overall about 3 million barrels of distillate fuel oil products (which includes heating oil and diesel) are used in the U.S. per day. However, demand is going down as more homes are switching to natural gas. As per the American Petroleum Institute, demand for heating oil has dropped by about 10 billion gallons/year from 1976 when demand was at its peak.
Internationally, heating oil is popular in other cold weather regions like Canada and Northern Ireland.
Who Invests and Trades Heating Oil Futures?
While heating oil futures may not be as popular as the futures of some other commodities—like WTI—but heating oil is still a heavily traded future. Heating Oil traders can be broken down into two main categories: hedgers and speculators.
The price of heating oil is influenced by many factors. In order to reduce the impact of these price fluctuations on producers or refiners, heating oil futures were introduced. Heating oil futures offer these market participants a way to hedge their risk and regain control over their heating oil investments.
Producers and Marketers of heating oil can minimize the risk of price fluctuations in the market by using a short hedge. This will set a fixed selling price for the heating oil that they will produce, so that they can get the specified amount in the contract, even if prices fall in the future. Consumers can use a long hedge to set a fixed purchase price for a specified quantity of heating oil.
Heating oil futures are also used as hedge against the prices of jet fuels or diesel.
Heating oil futures are popular because they are more liquid than diesel or jet fuel contracts that trade at a stable premium over the heating oil futures on the NYMEX. So people looking to hedge prices in those markets have a strong affinity for heating oil futures as well.
Heating oil futures are also traded by speculators. Speculators have no vested interest in the underlying asset, that is, they will neither deliver heating oil nor take delivery for heating oil. They trade in and out of heating oil futures only based on speculations about the price fluctuations of heating oil over the trading period. They take on the price risk that hedgers are trying to avoid, because they hope to profit from the price movements. Heating oil speculators buy futures if they believe that the price of heating oil will go up, and sell heating oil futures if they believe that the price of heating oil will go down.
Heating Oil Futures Contracts
Heating oil is traded on the New York Mercantile Exchange (NYMEX) in the U.S. and on the Intercontinental Exchange (ICE) abroad. Some futures are also traded at India's Multi Commodity Exchange (MCX).
Heating Oil futures trade on the NYMEX under the symbol "HO" with each contract representing 42,000 gallons (1,000 barrels) of fungible heating oil. Contracts are priced in dollars and cents per gallon and can be settled by physical delivery. They are listed for the current year, plus 3 years and 1 month. The contract is traded with an open outcry method (there is also an electronic method for trading) during all months of the year. It's minimum price fluctuation is $0.0001.
ICE lists cash-settled heating oil futures, with the symbol "O" and contract size of 42,000 gallons quoted in US dollars and cents, listed for up to 50 consecutive months.
How to Trade Heating Oil Futures: Costs and Different Brokers
You can trade futures by opening a trading account with a trusted broker who handles futures trading. CME Globex, CME Clear Port and Etrade are some well known online platforms for trading futures.
Most brokerages will charge the National Futures Association fees, which is roughly around $0.02 per side, along with a commission (which can range from $0.025 to $3 and more, per contract per side). You will also have to pay an exchange fee, which will vary depending on the exchange and the specific contract you are trading. Commodity futures will also have a high margin deposit. Be sure to look at the fine print and add up all the fees into your cost before placing trades.
Heating Oil futures come with several risks, so you should think carefully about your allocation.
The biggest risk with heating oil is the price volatility due to its seasonal demand and supply. Heating oil demand is highest during the winter months. However, simply buying heating oil futures during the winters is not necessarily profitable. If the winter is colder than expected and the demand for heating oil shoots up, futures may not provide enough hedging against price movements.
In the northeast, supply of heating oil comes from the Gulf Coast or Europe, and such transportation can take over two weeks, if delivery systems are also affected by the winter. In the case of colder than expected winters, local suppliers may run out heating oil in storage and fail to meet short-term spikes in demand. Buyers can get anxious during this time, causing prices to soar sharply until the new supply is available. Conversely, if the region has a warmer winter than expected, because of climatic changes, then heating oil prices can drop sharply.
Heating oil futures trading is also accompanied by several risks affecting the underlying commodities. If refineries run at capacity for large stretches of time during the prior summer to produce gasoline to meet a large demand, then the duration of time allotted for refining heating oil suffers and has a direct impact on its availability.
Furthermore, heating oil prices respond to crude oil price movements, so they too are subject to swift price changes arising from the global risks that affect crude oil markets.
Lastly, heating oil futures can sometimes magnify the risks in the underlying commodity owing to leverage. Leverage is a double edged sword. It allows traders to control a large amount of heating oil using a low margin. This yields a high ROI if the market moves favorably, as you expect, however, if there are unfavorable market movements, you may stand to face huge losses.