What are petroleum derivatives? (with photos)

A pump brings oil to the surface.

Oil derivatives are financial instruments that use oil, usually crude, as an underlying asset. The derivative has no inherent value and is just 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. These contracts have been a part of financial markets since the 1800s and provide producers of various products with a number of useful tools for doing business. Companies can use oil products to distribute and reduce risk, as well as to address issues such as not wanting to store oil for long periods of time.

Crude oil is generally the underlying asset of petroleum products.

The most basic oil derivative is a futures contract. When people prepare the contract, one of the parties agrees to buy a certain amount of oil at a certain price at a date in the future. Another form is an options contract, where people have the option to make a purchase on a certain date and can decide whether they want to exercise it. Petroleum derivatives allow people to manage risk; for example, a futures contract can help people avoid temporary volatility in the price of oil and get the oil at a guaranteed price. Options can provide hedging, creating an opportunity to buy below the market price or sell above it, depending on the contract structure.

Although petroleum derivatives were initially developed for use by the petroleum industry, other investors may trade them. In many cases, people who trade derivatives have no plans to receive the underlying asset; a Wall Street investor has absolutely no interest in a worthwhile oil tanker, but wants to take advantage of changes in oil prices to profit from its derivatives. These contracts provide a mechanism for investing in commodity trading. People can also buy and sell stocks and bonds issued by oil companies.

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Trading petroleum products requires industry knowledge, skill and the ability to make intelligent market forecasts. People rely on all kinds of data to make investment decisions. News can provide insights into possible future changes in oil prices, and people also pay attention to political developments, oil policy and issues such as consumer demand. Knowing, for example, that demand for oil tends to increase in the summer, people can plan their investments accordingly.

Derivatives trading is generally the purview of advanced investors or special funds. It can be risky, especially in high volumes and in a volatile market. Even skilled investors can make mistakes when it comes to predicting future financial movements, and this can translate into costly losses.

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