So when we talk about oil, what exactly do we mean?
Crude oil is formed when the remains of plants and animals are covered in sand and other organic matter, and over millions of years, the pressure causes them to turn into sedimentary rock and eventually oil.
Due to the fact that the oil is formed deep underground (either on land or under the sea), the extraction process involves digging deep into oil reserves, through layers of rock, and it is therefore very costly to extract and produce.
This cost of extraction is consequently factored into oil market prices, with an increased cost of production inevitably leading to an increase in oil prices.
Even more significant than the cost of extraction is the fact that there is only a limited availability of oil available anywhere in the world. Oil is found in only a handful of countries, the most significant of which are the 12 OPEC countries (Organization of Petroleum Exporting Countries), and together these 12 countries account for over 75% of all proven oil reserves in the world.
The most significant OPEC members include Saudi Arabia, Iran, the United Arab Emirates, Kuwait, Venezuela and Nigeria.
As a trader, we therefore need to constantly monitor levels of production, exportation levels, and any disruption that may occur in major oil exporting countries. Any increase or decrease in production will impact prices.
When calculating oil prices a huge consideration is the fact that oil is a finite resource which will one day run out. As supplies dwindle or become harder to extract, prices will increase. The long-term price trend for oil is therefore very much predictable.
Types of Oil Traded
When we talk of trading oil, the oils we generally mean are WTI, which is short for West Texas Intermediate oil (also known as Crude Oil) and Brent Crude Oil, often referred to as Brent.
WTI is produced in the USA and Brent is produced in the North Sea. Both are high-quality oils, and this means that once they have been extracted from the ground they can be refined to make it usable for lots of different purposes.
Uses include refining into petrol to power a car, as fuel in the generation of electricity and heating, and also to create plastics, petrochemicals and many other products. This, therefore, means that both WTI and Brent are constantly in very high demand around the world, and are consequently highly correlated.
Major Consuming Nations
Globally the largest consumers of oil are developed industrial countries such as the United States and European countries. However, over the last two decades, there has been a huge growth in consumption in the Far East, with China in particular now a major user.
The largest oil consumer nations include US, Japan, China, Germany, and the UK so when trading oil we always need to keep an eye on the major consuming nations to monitor whether their usage is increasing or decreasing.
An increase in demand will tend to mean an increase in prices, and similarly, a decrease in demand will tend to mean a decrease in prices (provided that supply levels remain consistent).
Volatility & Potential Opportunities
The fact that oil has so many uses means that it is one of the most traded and volatile markets in the world.
For traders this presents huge opportunities, but when trading oil we need to pay particular attention to a wide range of supply and demand issues which can potentially have a huge impact on prices, often in a very short timeframe.
A famous example of this is when oil rose to a record high of $145 in June 2008, only to then fall to around $30 by December of the same year. The record high prices were caused by a combination of factors, most notably supply disruptions in Nigeria due to political factors, combined with the belief that increased demand from developing nations such as China and India would outstrip supply.
However, within only a matter of months, these fears were dismissed by the markets, leading to a huge $110 price swing, down to roughly $30 and this presented a great opportunity for traders of all timeframes.
There are two specific oil reports that oil traders must be aware of. The first of these is the weekly Department of Energy (DOE) Oil Inventory. This is released every Wednesday and quantifies how much oil stock is left in storage, for use in America (the largest consumer).
If inventory figures increase it implies that there has been less demand than previous weeks, and hence prices should fall. If inventory figures decrease it implies that there has been higher usage, and prices should therefore increase.
Another key report we pay attention to is the periodic OPEC reports, in which they outline production quotas for member states, thereby determining how much supply will be made available to world markets.
Their production quotas depend upon levels of world supply and demand – if demand is high or supply is low OPEC will increase production, thereby lowering prices. However, if demand is low or supply is high, production levels will be cut.
The power that OPEC has in determining prices should therefore not be underestimated, and many people complain that the fact that countries eager to make as much profit as possible are responsible for determining supply levels is a potentially dangerous thing. This is one of the reasons why in recent years there has been a big push towards alternative fuel sources.
Another factor to be aware of when trading oil is that although oil is in high demand throughout the year, was tend to notice two seasonal periods where demand is larger than normal. These are the winter months, where oil is used as a heat source and during the summer months (known as the driving season) where there is an increase in petrol consumption due to families in America and Europe going on holiday.
Things to Take Away
- Crude oil is a finite resource, and the vast majority of world reserves are to be found in OPEC nations
- WTI and Brent are two of the most traded markets in the world
- Prices are determined by supply and demand factors which may range from seasonal factors and political factors to economic factors and consumption from developing nations
- Key reports oil traders must consider include the DOE oil inventories, and OPEC reports