By Owain Johnson
At A Glance
Physically delivered contracts like WTI crude oil provide consistency between the value of financial instruments and their underlying commodity.
The roots of physically delivered commodity futures go back to the 17th century Dojima Rice Exchange in Osaka, Japan.
Virtually all of the world’s major commodity futures contracts settle via a process of physical delivery. This is by design. Utilizing a mechanism that delivers the physical commodity at the end of the trading period ensures that there can be no discrepancy between the value of the financial instrument and of the underlying commodity.
How does physical delivery work? At the end of the first-listed trading period, which is when the contract can no longer be traded, customers holding long positions (buyers) will receive a delivery of the real commodity, whether it is crude oil or soybeans or copper, from customers that are still holding a short position (sellers).
This delivery process forces the futures contract to converge with the physical market since the futures position results in the delivery of the physical commodity. CME Group has facilitated the delivery of over 18 million barrels of WTI crude oil so far in 2020.
A Long History
The roots of Physically delivered commodity futures started in agricultural markets. The first contract goes back to the 17th century and the Dojima Rice Exchange, which was the world’s first commodity futures exchange in Osaka, Japan. The concept really took off in the 19th century with the agricultural exchanges founded in Chicago, which later became part of today’s CME Group.
Trading activity in New York followed a similar trajectory, and the New York Mercantile Exchange (NYMEX, now part of CME Group) also began by listing agricultural futures contracts, before later specializing in energy markets.
NYMEX launched the world’s first successful energy futures contract in 1978 with a heating oil future contract that is now known as New York Harbor ((ULSD)) Futures. The success of ULSD helped pave the way for the successful launch of WTI crude oil in 1983, the deepest and most liquid crude oil benchmark globally.
A well-designed physical delivery mechanism, like that of WTI, provides enormous stability and continuity. Only twice in over 40 years has there been a change in the specifications of WTI. Most recently, in January 2019, the exchange added five additional quality test parameters to ensure the quality of WTI was maintained amid a dramatic surge in domestic U.S. crude oil production.
Cash-settled contracts may require more revisions. Brent futures, for example, are unusual among major commodity contracts in making use of a financial index for settlement, and this index has required regular updating over the past two decades.
Planning for the Future
Physically delivered commodity contracts also offer benefits in terms of their convergence with the physical market and their potential to continue reflecting the same fundamentals over years and decades.
CME Group also adopted a physical delivery mechanism in the design of its WTI Houston (HCL) contract, which launched in 2018.
The WTI Houston contract provides the link between the main WTI market, based around Cushing, Oklahoma, and the growing Gulf Coast market, which based around the storage, refining and export hub of Houston, Texas. The new contract trades actively and has delivered almost 2.5 million barrels of physical crude so far this year.
Some 35 years separate the launch of WTI from the launch of WTI Houston, but both contracts continue to benefit from a firm ongoing commitment to physical delivery in the energy industry.
A well-designed delivery process ensures that derivatives converge with the physical markets upon which they are based. This establishes a clear view of the value of commodities, and a reliable market in which market participants can hedge and seek out future opportunities.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.