Futures Contracts
Oil futures are best understood as futures contracts. These are contracts to buy or sell a set commodity in a set quantity and at a particular date for a specified price. All sorts of things are traded in this way, particularly commodities such as agricultural products, precious and industrial metals, and energy resources like oil.
The Practical Use for Futures
In their simplest form, a futures contract takes risk out of the underlying equation in trading commodities. If the XYZ oil company wanted to guarantee the income on their product, they could negotiate contracts to provide oil to clients in set quantities, on set dates, and for set prices. They would therefore be insured against prices falling during the duration of the contract. On the other hand, the clients might also save money if price of oil were to go up during the duration of their contracts, because they would only be required to pay XYZ oil company the contracted price, not the prevailing market price. This is the simplest application of futures, and their original, practical application.
Speculation in the Futures Market
Futures are traded at exchanges. In the United States, two of the major exchanges are the New York Mercantile Exchange and the New York Board of Trade. This marketplace creates speculative activity for Futures. In the case of oil, if you thought the price of oil was going to go up to $200/barrel, you would buy up as many Futures as you can that were contracted to deliver oil at below that price. Conversely, futures-holders would be selling them if they expected the price of oil to fall below the price at which they were contracted to deliver that oil.
