Oil Trading Essentials

Jun 29, 2020 06:21 AM ET
Oil Trading Essentials

Introduction

Trading crude oil can offer several excellent opportunities for a trader in a myriad of market conditions, due to its unique position within the world's socio-economic and political systems. The Energy sector as a whole has seen sharp rises in volatility in recent years. The possibility of consistent returns from strong trends in the market is quite high, both in the case of long-term timing strategies as well as short –term swing trades.

Thus, many trading opportunities arise due to fluctuations in crude oil. However, most market participants fall short of taking advantage of this market. They are not aware of its specific characteristics and data, as well as frightened by the various pitfalls and political manipulations involved. Traders looking to trade crude oil should know all the types of instruments they have in their toolbox. We present the most crucial factors impacting oil prices, historical manipulations examples, and how you can take advantage of it. 

OPEC

The Organization of the Petroleum Exporting Countries of OPEC is a 13 nation intergovernmental organization. It accounts for an estimated 44% of the global oil production as well as 81.5 percent of the world's proven oil reserves. It thus has a significant influence over the world's oil prices. The organization as of January 2020, consists of 13 member countries. These include the African countries of Algeria, Angola, Gabon, Equatorial Guinea, Libya, Nigeria, Republic of Congo, the Middle-eastern countries of Iraq, Iran, Kuwait, United Arab Emirates, and Saudi Arabia and the South American country of Venezuela.

The roots of OPEC can be traced back to 1949 when Venezuela and Iran took the first steps to establish what we know as OPEC today. It was officially founded on September 14, 1960, in Baghdad by the first five members, Iraq, Iran, Saudi Arabia, Kuwait, and Venezuela. In 2016, it expanded into a larger group called OPEC+ to increase the influence over global crude oil prices by adding Russia, Mexico, and Kazakhstan to a cartel.

OPEC functions as a cartel with its member countries agreeing upon the total volume of oil they will produce. It directly influences the ready supply of crude oil in the global market and indirectly over the global market price as well. Thus OPEC+, can exert influence over global crude oil prices and tend to keep the prices relatively high for maximum profitability.

OPEC can choose to either cut the supply of oil to increase prices or can decide to increase supply. As the forces of supply and demand govern the price equilibrium, announcements made by OPEC+ can alter expectations and affect the price of oil. Thus, OPEC must maintain a balance between too high or too low oil prices. Low prices can put the countries budgets into the red. High crude oil prices can inadvertently decrease sales as it can put downward pressure on demand. Conditions where supply and/or demand were dramatically affected usually triggered oil crises and volatility in the commodity. 

Oil Crises

The Oil crisis of the 1970s

  • The oil crisis of 1973: Beginning in October 1973, the 1973 oil crisis was caused mainly by the oil embargo proclaimed by the Organization of Arab Petroleum Exporting Countries. It had a political reason to it, as the embargo targeted nations supporting Israel in the Yon Kippur War. Initially, the United States, Canada, Japan, the Netherlands, and the United Kingdom, were targeted with an embargo, which was later expanded to include Portugal, Rhodesia, and South Africa. The price of oil, which was the U.S. $3 initially, increased about 400% to nearly $12 at the end of the embargo in 1974, with U.S. prices significantly higher. This oil embargo had many short and long-term socio-political and economic effects on global politics and economics

  • The oil crisis of 1979: The Iranian revolution was the major cause behind the Oil crisis of 1979, resulting in decreased oil output. Even though the oil supply decreased by a mere 4%, the widespread panic that ensued, drove prices higher internationally. As long queues appeared in front of gas stations in the U.S., the price of oil increased to $39.50 per barrel over the next year. Several other incidents, such as the Iran-Iraq war caused oil productions in Iran to a screeching halt. Oil prices finally started to recover to pre-crisis levels well into the mid-1980s.

The Oil crisis of the 1990s

The Iraqi invasion of the sovereign country of Kuwait by Iraqi dictator Saddam Hussein was the main cause for the oil crisis of the 1990s, also termed as the "mini shock." Compared to previous oil crises, the spike in price was less extreme. However, it nevertheless contributed to the recession of the early 1990s. The oil prices increased to $36 per barrel from $17 per barrel between July and October 1990. Prices began to fall when concerns about the long-term oil supply shortages eased after the US-led coalition succeeded against the Iraqi forces.

The Oil crisis of 2020

The Oil crisis of 2020 became a large war for the market share between Saudi Arabia and Russia. Saudi Arabia triggered this crisis in retaliation for Russia's refusal to reduce oil production to stabilize prices. Saudi's immediately proposed the commodity to China for a discount and increased oil production. The ongoing COVID 19 pandemic also contributed to the result. Business and travel lockdowns caused a shock to the market demand, which led to the deficit of empty storage for a massively produced oil. Uncontrollable levels of supply with a mix of low demand sent oil futures prices below zero. Traders, holding short term oil futures contracts, were selling them even at a negative price. Else, they were to fulfill the delivery and storage obligation, which would cost them much more.

Crude Oil Inventories

Crude oil inventories influence oil prices and provide insight into the balance of demand and supply in the oil market. As the price adjustments in the case of oil can be instantaneous, traders can question the demand for oil at the current price if oil inventories suddenly go up. This can cause a price retreat by the traders selling their positions. Similarly, traders may buy back into the oil market when oil inventories decline, bidding up prices in the process.

The EIA or US Energy Information Administration provides a weekly report on domestic inventories. Oil prices react instantly following the weekly inventory report from the EIA if it differs from what analysts expect.

WTI and Brent: What’s the difference?

WTI (Western Texas Intermediate) and Brent are the two most commonly traded crude oil types in the world and dominate the oil market, hence dictating the pricing in their respective markets. However, there are differences between the two, based on extraction location, geopolitical, content, compositions and prices. 

Point of Difference

WTI

Brent

Extraction location

Primarily extracted in North Dakota, Louisiana, and Texas. Transported through pipelines.

Primarily extracted from the North Sea oil fields

Geopolitical influence

Any U.S. based disruptions have an impact on WTI prices, as it causes changes in the WTI-Brent spread

Rising tensions in the Middle East have an impact on Brent oil prices, resulting in sharp price movements due to speculation

·  Content and composition

Easier to refine, as it has a 0.24% of sulfur content.

Has more sulfur content at 0

.37%

Where they are traded

Futures contracts are traded on the NYMEX (New York Mercantile Exchange)

Futures contracts are traded on the London based  ICE or Intercontinental Exchange

Benchmark

WTI is considered the benchmark for U.S oil prices

Brent is considered the global benchmark as nearly 66% of global oil contracts are traded in Brent

How to Trade Oil

Several different types of oil and oil-linked assets trade daily on the oil market. Oil prices are prone to massive fluctuations as oil is a finite resource. Given below are the different types of trading instruments

  • Oil futures: Oil futures refer to contracts in which the trader agrees to exchange an amount of oil, at a pre-set date and price. Oil futures are usually traded on exchanges and reflect the demand for different types of oil. Trading in Oil futures is one of the most common methods of buying and selling oil. The West Texas Intermediate is considered as the benchmark futures contract in the U.S. Since it is traded on the NYMEX exchange, it is referred to by traders as NYMEX WTI crude oil futures.

  • Oil Options: Crude oil options are considered one of the largest energy derivative products in the world. The underlying asset for these options are not actually crude oil itself.’ They are actually options on oil futures. Unlike futures, the holder of the option has more flexibility, as options are not required to be exercised upon expiration.
    Market events such as EIA inventory data, geopolitical events, or OPEC reports, and announcements can have a severe impact on the volatility of crude oil prices. Traders can utilize crude oil options for hedging against physical price exposure, during any global event. Oil producers use long put options for hedging from a price decline, while airline companies defend from fuel price increase with long term calls.  NYMEX Brent Crude Oil Options and NYMEX Light Sweet Crude Oil Options are examples of oil options.

  • Oil ETF: Oil ETFs refer to the exchange-traded fund which invests in companies engaged in the gas and oil industries. When trading Oil ETFs, investors do not deal in futures and hence do not have to worry about physical inventory. ETFs can also be used to invest in a basket of oil stocks or oil benchmarks. Examples of some of the best performing Oil ETFs include United States Oil Fund, LP (USO), ProShares Ultra Bloomberg Crude Oil (UCO) and WisdomTree Brent Crude Oil

  • Oil CFDs:  With CFDs, traders can trade in the price changes of options and futures, without themselves having to buy or sell the contracts. Traders can create an account with a leveraged provider to trade, instead of trading on an exchange. 

  • Oil Investment: Traders can get exposure to oil by purchasing shares of oil exchange-traded funds or companies. The price of oil usually influences the prices of oil companies and can thus offer more profitability in trading as compared to trading the oil directly. Examples of major oil companies stocks are Exxon Mobile (XOM), Chevron Corporation (CVX), Royal Dutch Shell (RDS-A), TOTAL (TOT), British Petroleum (BP)

Conclusion

There are several factors that determine oil prices that traders should learn besides the overarching influence of supply and demand. Factors such as global economic performance, oil storage, the push for alternative energy solutions, and the influence of OPEC contribute towards affecting both supply and demand. 


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