Why Trade Oil?
FXPRIMUS now offers new popular tradable instruments on Brent Crude Oil (ticker name UKOIL), WTI (ticker name USOIL) and Spot Oil which doesn’t expire. Discover our special report on Oil, produced by our award-winning Head of Investment Research, Marshall Gittler, in order to help you with your trading decisions.
- Oil trades partially like a commodity and partially like a financial asset.
- Investors need to understand the factors at work in the market – the factors affecting the supply of and demand for – oil before they can trade with any confidence.
- This note explains the basics of the oil market: what it is that investors can trade and what determines the price.
Oil has been in the news a lot recently. The market is extremely volatile – the price dropped 75% between June 2014 and February 2016, only to rebound nearly 70% in the following two months.
If you are interested in buying or selling “oil,” what should you do? You can’t just buy “oil,” like you can buy “gold,” because there are so many different kinds of oil from different places.
The main terms used for describing oil are sweet and sour. This refers to the amount of sulphur in the oil. Oil can also be described as light or heavy, based on how easily it flows and how dense it is. Light, sweet crude can be processed with less sophisticated and energy-intensive refineries and made into cleaner, more energy-intensive products than the heavy, sour crudes. The former are therefore usually more expensive than the latter.
Because the quality of crude varies so much from place to place, the price is usually set in reference to a benchmark. That is, a few crudes trade in the open market and a public price is established for them. Then other crudes are priced at a premium or discount to those crudes.
The main benchmark crudes are West Texas Intermediate (WTI) in the US and Brent in Europe. WTI is a blend of several US oils from Texas (of course) while Brent comes from various fields in the North Sea1. WTI is used as the main benchmark for US oil, while Brent is used for pricing oil produced in Europe, Africa and parts of the Middle East.
Both WTI and Brent are light, sweet crudes; WTI is slightly lighter and sweeter than Brent and therefore historically was a bit more expensive, although in recent years the supply of WTI has increased greatly and pushed its price down below Brent. There are many investors who trade the difference between these two oils, rather than taking a view on the direction of oil itself.
Our platform offers contracts on both WTI and Brent. Our contracts are based on the price of the listed oil futures2 contract. WTI (technically the light, sweet crude contract) is listed on the New York Mercantile Exchange, or NYMEX, while the Brent contract is listed on ICE (Intercontinental Exchange). We use the contracts that are closest to maturity. To avoid the problem of having to close out a position when the futures contract matures and open a new position, we also offer a non-expiring contract that automatically rolls from one futures contract into the next one, thereby allowing an investor to hold the position indefinitely.
What moves oil prices?
The price of oil, like most other freely traded products, is set by supply and demand. The supply is of course determined by how much oil can be pumped at any given time. The factors that determine demand however extend far beyond just how many people are driving to work every day.
Until recently, the supply of oil was pretty steady in the short term, because it takes a long time to find and develop an oil field. Therefore, until recently the majority of short-term changes in output were those that caused a reduction in supply, not an increase.
Sometimes oil production gets disrupted by mechanical difficulties, weather or terrorism. Sometimes producers just shut down operations for maintenance. Oil fields also get exhausted over time.
Reductions in supply naturally tend to push up prices.
Sudden increases in supply, on the other hand, historically came from only a few places. First, of course when those obstacles or disruptions that caused a decrease in supply end, supply naturally comes back to the old level. Secondly, some countries – notably Saudi Arabia – kept some supply capacity in reserve and could increase output if prices got too high.
However, the oil world has changed in recent years because of the development of hydraulic fracturing, or fracking. This is a technique whereby liquids are injected into oil wells at high pressure, fracturing the rocks and releasing oil and natural gas. Combined with new developments that enable operators to drill wells horizontally, fracking has boosted US oil production by 80% and turned North America into the world’s largest oil producer, producing around 40% as much as all the OPEC countries together. This has eroded the power of OPEC and Saudi Arabia to control the supply of oil and therefore its price.
Fracking is qualitatively different from previous methods of drilling for oil and has changed the nature of the oil game. Previous methods of producing oil were heavily capital-intensive and took a long time to develop. Fracking wells on the other hand are cheaper, faster and easier to turn on and off. The supply of oil therefore reacts more quickly to the demand.
The increase in supply from fracking in the US is one of the major factors that has pushed oil prices down over the last year or so.
To keep track of the supply of oil in the US, market participants watch the Baker Hughes Rig Count every week. This is a weekly tally of how many oil and gas rigs (the towers that are used to support an oil drill) are in operation in the US and Canada. (Data on other countries is available monthly.) However, improving technology has enabled drillers to drill more wells with one rig and to get more oil out of each well, so the amount of oil being pumped is less closely correlated with the number of rigs in use than it used to be.
Fracking has changed nature of the oil market in another important way: by making oil production sensitive to the financial cycle. The small operators who specialize in fracking depend on bank loans. Thus the supply of oil, at least in the US, has become more responsive to credit conditions, an entirely new development for the oil market.
The demand for oil varies regularly according to the seasons. In the summer, people drive more; in the winter, they heat their homes. This causes a stocking/destocking cycle for oil as refiners build up inventories of gasoline in the spring and heating oil in the fall ahead of these peak demand periods and then run down their inventories as the season progresses.
Naturally, any disruption to usual seasonal patterns will cause a disruption to the usual pattern of consumption. For example, unusually warm weather can cut into demand for oil in the winter, while unusually hot weather in the summer can increase demand for air conditioning. Weather reports are therefore required reading for the aspiring oil trader.
Oil demand also varies with economic growth. When the economy is booming, industry uses more energy to produce and ship more goods. In recessions however it all goes in reverse and oil usage falls. This is why oil prices respond to economic indicators of overall economic conditions, such as GDP figures or the Purchasing Managers’ Indices (PMIs), as well as consumer sentiment, retail sales, etc.
Similarly, economic development has caused a large increase in demand for oil over time, because people with a higher income and higher standard of living tend to use more energy (up to a point).
The major oil-consuming countries are:
Note that the US, Europe and China alone account for nearly 50% of world oil use, which is why the oil market is particularly sensitive to indicators of growth in those three regions. India is also a major oil consumer with no significant domestic production.
On the other hand, technology is starting to make inroads into oil demand. Renewable energy has cut into demand for oil somewhat, as has internet shopping (by reducing the amount of driving people do). So while technological progress in developing countries often means greater use of energy and more demand for oil, in the developed nations it can have the opposite effect.
How to evaluate the supply/demand balance: inventories
It’s hard to gauge directly either the supply or the demand for oil. Accurate data on the supply of oil is available only with a lag, and even that can’t always be trusted as some producers may have an interest in exaggerating or hiding their production. Demand is easier to gauge, at least in the developed world.
Nonetheless, the balance of supply and demand can be seen quite readily by looking at inventories of crude oil as well as oil products. In effect, oil goes in the top of the tank (supply) and comes out the bottom (demand). If the amount of oil in the tank rises, then supply exceeds demand. If the amount falls, then demand exceeds supply.
This is why the weekly inventory figures from the American Petroleum Institute (API) and the US Department of Energy’s Energy Information Agency (EIA) are closely watched. As the table above shows, the US accounts for around 20% of world oil consumption. Its supply and demand is the most important factor. The EIA data also includes initial estimates for US oil production. More accurate figures are available some time later when the monthly numbers come out.
The seasonal nature of the oil market means that inventories have to be evaluated in relation to the average for that time of year. Usually, investors compare the current level of inventories to the average for that week for the last five years or so.
Supply and demand aren’t the only things that move the market, nor even the major things. The major factor nowadays is expectations about supply and demand.
According to researchers at the European economic think tank Bruegel, since the financial crisis of 2008, the factors driving the oil market have changed dramatically. Nowadays, supply accounts for only about 15% of the change in prices and demand, 12%. The bulk of the change in the price of oil – 73% -- is due to changes in expectations.3 Oil is trading much like a financial product in which the role of speculators has become dominant.
Then we have to ask: what affects expectations?
One of the major points, as mentioned above, is economic indicators. Market participants form views on future demand for oil by considering what the level of economic activity is likely to be in the future. Weather and other factors that could disrupt supply or change demand are big factors too.
There is also one major factor: geopolitics and particularly the geopolitics of the Middle East.
Much of the world’s oil is located in countries that are not particularly stable, such as Iraq and Libya. Investors are constantly watching for signs of trouble in these countries that might restrict supplies.
One particular flashpoint is the Persian Gulf. This narrow body of water is only 56 km wide at its narrowest part, the Straits of Hormuz, and the shipping lane is only 3.2km wide. Yet this gulf is the world’s largest single source of oil: in 2011 some 20% of the world’s traded oil sailed through that narrow space every day. (The percent is probably lower now because of the increase in US oil production, but it’s still a lot.) Thus any tensions in that area have an immediate impact on oil prices on the possibility that the supply of oil might be interrupted. There are other choke points throughout the region too that mean politics there have an immediate impact on oil prices as well.
The point is that it’s not necessary for events to cause any disruption to the supply of oil; just the possibility that they might cause a disruption is enough to send the price higher. Oil refiners will rush to buy oil and put it in storage so that they will have enough supplies even if oil becomes unavailable. Others will hedge their risk by buying oil futures, and that will naturally push up current prices too.
In short, traders wishing to speculate on the price of oil should consider all the factors that might possibly at some time in the foreseeable future affect the price of oil, and trade accordingly.
The connection between the oil market and the FX market
There is a close connection between the oil market and the FX market. There are several reasons for this:
- For some countries, particularly Canada, Norway, and Russia, oil is their main export. Therefore a change in the oil price has an immediate impact on their terms of trade (the value of their exports as compared to the value of their imports) and an immediate impact on their currency.
- On the other hand, other countries – particularly EM countries – are net importers of oil. Their terms of trade and their current account balances are affected by the price of oil too, in the opposite direction.
- Oil prices tend to move along with economic activity, and so do many currencies.
- Oil prices tend to rise when geopolitical tensions rise, and periods of geopolitical tensions tend to be periods of risk aversion, with implications for currencies.
- Oil is usually paid for with dollars. As a result, when the price of oil rises, global demand for dollars rises. These dollars are not recycled back to the original countries in the same ratio – for example, Eurozone countries may buy more dollars to pay their oil bill with Saudi Arabia. However the Saudis will not necessarily spend those dollars in the Eurozone but rather may choose to save some of them in dollars.
- On the other hand, since oil is paid for with dollars, the price of oil tends to fall when the dollar rises, because it becomes more expensive for countries outside the US to buy oil. The reverse also happens. Other dollar-denominated commodities, such as gold, show this kind of behavior too.
The oil market is therefore important for FX investors to watch as well.
The table below gives the correlation between weekly changes in WTI and Brent prices on the one hand and the major currency pairs on the other. It also shows some more unusual currency pairs that are particularly correlated with oil. Notice how CAD, RUB, NOK, MXN and AUD are the most closely correlated.
Australia is not a particularly big oil exporter, but it does export coal, the price of which depends to some degree with that of other energy sources. Probably more important though is the fact that its economy is closely tied to that of China, and expectations for Chinese economic activity tend to move the oil price. The yen on the other hand seems to weaken when oil prices go up, in the crossrates (CAD/JPY and AUD/JPY) more than in USD/JPY or EUR/JPY. That could be because since the Fukushima disaster, Japan shut down its nuclear power stations and has had to import large amounts of oil, which reduced its current account surplus.
FXPRIMUS Launches New Range Of Tradable Instruments, With Special Emphasis On Commodities.
Monday 13 June 2016, Limassol Cyprus,FXPRIMUS The Safest Place To Trade has announced the launch of new popular tradable instruments: Brent Crude Oil (UKOIL) and WTI (OIL), and Spot Oil (which is non-expiring).
This move follows the launch of FXPRIMUS’ new three pillar strategy1 to provide SAFETY through EDUCATION and TECHNOLOGY, whereby the company places greater emphasis on the provision of the highest quality services and products to its clients.
Brent Crude and WTI - known respectively as sweet light crude and Texas light sweet - have been identified by the Company as tradable instruments of significant popularity further to increased demand from clients to trade on the oil rally. www.fxprimus.com/en/oil
In response to the growth in popularity of trading on oil and other commodities during this time, clients can register to trade both on futures and spot oil which is non-expiring, in order to benefit from competitive trading conditions including some of the industries tightest spreads from $0.05
Director & CEO of FXPRIMUS The Safest Place To Trade, Terry Thompson commented “Our decision to extend our range of tradable instruments evidences our determination to provide the most relevant products to our traders who are both interested in commodities and in diversifying their trading portfolio.”
ABOUT FXPRIMUS, The Safest Place To Trade
FXPRIMUS offers one of the most secure online trading environments available anywhere in the forex industry. Its industry-leading safety mechanisms are built to withstand any unexpected market volatility and to fully protect client funds. The company enables clients of all experience levels to trade multiple instruments including forex, commodities, energies and indices, via a range of advanced web and mobile trading platforms. Clients of FXPRIMUS are supported through their unparalleled trading experience with the most innovative tools and resources, and best financial education, supported by our celebrated Head of Investment Research, Marshall Gittler. The company also actively empowers traders of all experience levels, with the skills and the knowledge to make effective trading decisions, helping them to achieve sound financial success.
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