Money: So where do you want this oil, mate?

You're a commodities trader. You've bought 1,000 barrels of North Sea crude. Why don't you have to take delivery? Stefan Bernstein explains
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The Independent Culture
HOW MANY times have you seen it? Oil prices drop and the cost of petrol stays the same or even rises. The world's commodities are getting cheaper, but the average person doesn't benefit. Of course, when the reverse is true and oil prices are on the way up, pump prices are quick to follow suit. A lose-lose situation for the motorist.

Well here's a way that even small investors can fight back. With a little research and astute timing, you're profits could pay for all the fuel you'll ever need. And, along with the profits, you have the added advantage of feeling like a big-time investor without the financial backing of George Soros.

Call it commodities trading or dealing in futures, it still has a ring of mystery and excitement about it. It may simply be because so few people really understand what happens in the various dealing rooms and trading pits where chaos seems to reign, and those with the loudest voices and wildest gesticulations seem to come out on top. But the world's commodities markets are really nothing to be afraid of.

Whether it is the price of oil, some other physical commodity such as sugar or coffee, or an intangible such as a stock index, the commodities markets trade according to strict "contract" specifications. These contracts specify fixed delivery dates and standard nominal values so that all the players in the market understand what it is, exactly, they are agreeing to buy or sell. So, anyone with access to a broker can trade in commodities.

For example, you might be happy to trade in an oil contract, but you will want to know the quantity of oil involved, the delivery date, the price and its grade. All these features are set down in considerable detail by the various markets (such as LIFFE, the London International Financial Futures and Options Exchange), and this allows individuals to react quickly without ever having to think in depth about whether or not the "asset" in question is suitable. If someone buys a contract, then he is obliged to buy the asset on a particular date. If someone were to sell a commodities contract, then they would have to sell the particular assets in question on a particular date.

As always, an example is the easiest way of understand why anybody would do this.

Imagine you are a speculator and you think that the price of oil is about to rocket because of difficulties in the oil producing regions. You would probably buy a futures contract and would therefore be taking a "long position". Let's say the current futures prices of oil is pounds 100 per contract (for easy reckoning). If, during the life of the contract, the price of the contract itself should rise to, say, pounds 150, due to the perceived shortages actually becoming reality, then you would simply then sell your contract at pounds 150 having made a handsome 50 per cent profit. At the same time the price of oil company shares may rise, but it would be by a much smaller amount. The best you could hope for in the equities market would be 4- 5 per cent.

It is important to understand that when you buy a commodities or futures contract, the most you can actually lose is the total amount of your investment - pounds 100 in the above example if oil should become worthless. This is, of course, highly unlikely, and you should have the opportunity to follow the price down and salvage at least some of your money on the way out. The amount of profit you can make, however, is virtually unlimited.

You can also profit from falling prices. Imagine you hear that huge amounts of oil are about to be discovered in Antarctica and that this will halve the price. In this case, you can go out and sell the contract you bought in the previous example, for the same amount. You have now received pounds 100 but you are obliged to make delivery of the oil on the specified date. Of course, you know that oil will collapse in price, that you will be able to buy the contract to close out your position at pounds 25, and will therefore make pounds 75 profit.

The placing of an order in the commodities market is devastatingly simple once you have established a trading account. Imagine for example that you expect the price of oil to go down shortly. You will simply call your broker's trading desk and give your account number, asking to sell one June oil contract at the market. Your broker should hold for a few seconds before confirming that the deal has been done. This will be executed directly to the relevant trading floor at the relevant commodities exchange either by computer or by telephone. Your broker should then respond to the effect that you have sold one June oil contract at $YY per barrel.

If you take out a long position in some commodity and you choose not to close the position, or forget to do so, what happens? If you'd purchased six tonnes of Robusta coffee, would a couple of lorries appear in your road, and promptly tip out a mountain of beans on your drive, the day after the contract expires?

Well, before you arrange coffee mornings for the next 30 years, this will not happen. As your contract nears maturity, be it long or short, your brokerage firm will be keeping a wary eye on it. Some time before "delivery". the firm will telephone all open long position holders and tell them to either close their position or prepare to take full delivery and also pay the value of the underlying contract. Similarly holders of open short contracts will be asked to close out their trades or make ready to deliver the underlying commodity (and show they have the required quantity and quality available).

Even manufacturers and processing companies who trade with the commodity rarely take delivery of the underlying goods. This is because the commodity contracts are rarely in the exact quality or grade that they need.

Instead they will close their position, having successfully hedged against price movements, and buy in the cash market. The cash market price will have followed the commodity price throughout the period in question. Only those companies who trade in a commodity for which they can find buyers of many different grades tend to take physical delivery.

Stefan Bernstein's book `Understand Commodities in a Day' is available for pounds 6.95, post-free, from TTL, PO Box 200, Harrogate HG1 2YR. Or fax credit card details on 01423-526035 or email