Crude Oil Trading

This post will explain Crude Oil Trading in detail. Factors affecting global crude prices are also discussed. Guidelines for effective Crude Oil Trade are covered as well.

What is Crude Oil?
Crude Oil is one of the most valuable natural resources. It is a major source of energy. Crude is refined into many different petroleum products before it reaches the end consumer.

Composition of Crude Oil
Crude Oil is comprised of that segment of world oil supply that is extracted from US soil. Its reserves are also found under water where offshore platforms need to be established for extraction. This extraction technique enhances cost but is widely used.

Post extraction phases
Crude is not at all useable when extracted. It is nothing but a dark black thick liquid. The oil is then shipped to refineries either through pipelines or vast oil tankers.

How is Crude Oil Traded?
Crude Oil is one of most actively traded commodities at Chicago Mercantile Exchange which is among the largest exchanges of the world. The 2 main modes of trading crude oil are:-

1. Spot:-
This trading is suited to those buyers and sellers who immediately want settlement. Spot counter is also known as ready market as there is almost no lag between transaction and delivery.

2. Futures Trading:-
Crude Oil futures contracts are widely traded across the globe. These are standardized contracts of 1,000 barrels each with an expiry of approximately 4 weeks.

The price of crude futures contracts are linked to spot price of crude which means that if spot price increases, so does the price of futures contracts.

Participants of Crude Oil Market:-
The major participants of this market are oil extraction companies who are pumping millions of barrels of crude oil each day into the global oil supply. They widely use crude futures contracts to hedge against oversupply concerns especially when they feel the prices to be overvalued.

Another key player is oil marketing companies (OMCs) who procure crude oil in view of expected demand of finished gasoline products. OMCs extensively use crude futures contracts to hedge against price risks and demand related concerns.

Then there are large hedge funds and speculators who craft earning opportunities from price fluctuations in the futures market. They improve the overall liquidity in the futures market by taking long or short positions based on their future price projections.

Marco-factors that affect global Crude Oil prices:-
• Projections for U.S crude oil production inversely relate to price as it creates oversupply concerns.
• Strong domestic demand in the U.S exerts upward pressure on crude prices.
• Seasonal supply disruptions caused by adverse weather push oil prices higher.
• Unforeseen supply troubles such as damage to oil pipelines result in price spikes.
• Political disturbance in major oil producing countries increase demand for US Crude.
• Military tensions or conflicts surrounding key oil producers hike oil prices.

Micro / US specific factors affecting Crude Oil prices:-
In addition to the above macro factors, there are a few variables specific to America.

1. Domestic US Demand:-
USA is among the world’s largest economies. This also makes it one of the major consumers of oil. Overall US demand is positively correlated with its economic health. If US economy is doing well, it implies a strong domestic demand for oil.

2. Shale boom of USA:-
Not long ago, America was one of the largest importers of oil. It was mainly due to 2 factors:-
a) As a strategic move, it did not want to consume its domestic crude oil reserves.
b) Shale technology initially was very expensive and importing oil was financially more viable.

This was followed by the shale boom of USA. Shale is a relatively new oil extraction technique which is effective for oil reserves that are geographically dispersed. Initially, shale technology was very expensive and lead times for setting up and dismantling oil rigs were much extended.

With extensive R&D in shale production, the technology not only became highly cost effective rather lead times for shale rigs were also drastically reduced. Shale was extensively adopted by all major US oil exploration companies and US oil production skyrocketed.

Presently, USA has become the largest global producer of oil which not long ago was an importer. This created many new markets for American crude which is now being supplied as far as Asia as it is strongly competitive.

3. US Crude Oil Inventories:-
Existing inventory levels in the USA and Crude Oil prices are inversely related. Rising inventories imply either increased supply or reduced demand. Crux of the matter is that increasing levels of crude inventories are not good for crude oil prices.

Two American agencies named American Petroleum Institute (API) and Energy Information Agency (EIA) release US inventories data on Tue and Wed of each week respectively. Data released by EIA is regarded as the official one and carries more weightage in the eyes of market players.

The released inventory data is compared with last week’s inventory levels. If crude oil inventory levels show a decline from previous week, it is perceived positively the markets. The fall in levels of inventory is attributed to strong demand both domestically and internationally.

4. Baker Hughes rig count:-
Another key data on crude oil production is released by Baker Hughes on Fri of each week. This is commonly known as Rig Count. This is a data of active oil rigs pumping oil in the USA and Canada.
If the number of active oil rigs increases as compared to the preceding week, it is implied that the demand / production has increased. This is perceived by the market participants as negative for crude prices and it creates oversupply jitters in the market. It is pertinent to note that only major variations in weekly rig count create high price volatility.

Correlation of US Dollar with Crude Oil Price:-
Dollar strength and crude oil prices have a negative correlation. It means that a strong or rising American dollar puts downward pressure on crude price. Reason is that as dollar gains in value, crude becomes costlier for buyers. This is particularly true in the short and mid-term. In the long term though, demand and supply play a decisive role.

Trading opportunities in Crude Oil:-
The above cited macro and micro factors create very high volatility in crude oil prices. This presents a major opportunity for speculators whether big or small. “Margin Trading” is extensively available in crude oil trading further enhancing prospects.

Conclusion:-
Prior to trading crude oil, it is imperative that all major variables are understood along with their imminent effect on price. The relative weightage of each factor in a given circumstance is also vital for successfully trading in crude oil. Being a highly volatile commodity, it is strongly advised that Crude Oil Trading be done with proper risk management in place.