Oil Commodity Trading

In This Guide :

Before the Industrial Revolution, agricultural staples like corn and wheat ruled the commodities market. Today, however, crude oil and its derivatives are the most actively traded commodities in the world. That’s not surprising, considering oil touches just about every aspect of the global economy, in terms of consumer goods themselves as well as their production and transportation.

Here’s a look at the basics of investing in oil and the various oil trading opportunities.

Crude Oil and the Global Oil Trading Market

If you think of oil mainly as fuel to power cars, trains, jets, and ships, you’re only seeing a tiny piece of the puzzle. Oil is a major component in the manufacture of plastics, synthetic textiles (acrylic, nylon, spandex, polyester), fertilizer, computers, cosmetics, and even steel. In fact, less than half of a 42-gallon barrel of oil actually goes to fuels production; the rest is used to make consumer goods. It’s estimated that the average American uses about three gallons of petroleum products per day.

Although the market for oil is global, oil trading has clustered around several primary regions. The crude oil in each of these regions has slightly different characteristics, typically referred to in terms of viscosity (light versus heavy) and sulfur content (sweet versus sour). Each of the major trading regions has established benchmarks to track price movements in oil commodities, the most important of which include:

  1. West Texas Intermediate (WTI), which is a “light sweet” crude oil, with gravity of around 40 on the American Petroleum Institute (API) gravity scale and low sulfur content.
  2. Brent Crude is a light sweet crude oil from the North Sea. Its gravity is similar to WTI, but its sulfur content is slightly higher. From an oil investing point of view, it’s closest in quality to WTI.
  3. Dubai Crude, also known as Fateh, is denser (heavier) than both WTI and Brent and has a higher sulfur content, making it a sour crude. It’s useful in oil trading as a benchmark for oil shipments in the Middle East.
  4. OPEC Reference Basket is the weighted average of the mix of crudes produced in the OPEC region. It is heavier than both WTI and Brent.
  5. Bonny Light is a light sweet crude from Nigeria that’s useful as a benchmark for African oil. Its properties are similar to WTI and Brent, and in fact, demand for Bonny Light is primarily driven by European and American oil refineries.
  6. Urals is a heavy sour crude representative of Russia’s oil exports.

Historically, the world’s largest oil producers include:

  1. Russia
  2. U.S.
  3. China
  4. Canada
  5. OPEC members: Saudi Arabia, Iran, Iraq, and the UAE

There are four types of crude oil commodity.

  1. Light Crude Oil
    This has a low density, and is therefore easier to transport and refine. Chemically, it is ‘closer’ to finished products, such as petroleum and diesel, and as a result requires less refining and processing. This makes it more valuable and therefore more expensive to purchase.
  2. Heavy Crude Oil
    By contrast, has a higher density, and is harder to transport and refine. This makes it cheaper to purchase. However, the cost of drilling it can be twice as much.
  3. Sweet Crude Oil
    Has a low sulphur content, and has fewer impurities. This makes it cheaper to refine.
  4. Sour Crude Oil
    Has a high sulphur content, which means it contains more impurities and is costlier to refine. Companies have to get the balance right and choose the oil that will be cheapest to drill, refine and convert in the most economic way.

What Affects The Price of Oil?

In financial terms, oil is a “fungible” commodity, which means that specific grades of oil are identical for oil trading purposes, regardless of where they were produced. For example, a contract for 1,000 barrels of WTI crude will be exactly the same product whether the oil was extracted in Texas or North Dakota.

As with all commodities, supply and demand play a major role in oil pricing, although the global pool of oil and the ease with which oil moves around the world levels some of natural price pressures of supply and demand. It also tends to somewhat limit the influence of one particular producer or other in the global market.

In addition, new resources have come online, specifically Canadian oil sands and U.S. shale oil, which add to the global supply, exerting downward force on oil prices in times of heavy demand. However, extraction costs for these resources mean these oils are only competitive in a lower supply and therefore higher price environment.

That said, the International Energy Agency (IEA) predicts growing global demand buoyed by an increasing world population, increased energy consumption in developing countries, and growth in the road transportation, petrochemical, and aviation industries. Even though OECD (Organisation for Economic Cooperation and Development) countries are reducing their road transportation oil consumption on a per-vehicle basis, the growing automobile fleet in developing countries far outpaces those minor reductions.

4 Reasons You Might Invest in Oil

Crude oil investing has several advantages over traditional equities for certain trader classes. Depending on your investment objectives, oil trading can be used for:

  • Diversification. Adding oil commodities to an equities-only or fixed-income portfolio lowers the overall volatility because there is non-correlation between these asset classes. Commodities like oil are useful in countering price movements in a traditional portfolio.
  • Safe haven. Commodities are helpful during periods of global economic uncertainty because they tend to retain their value even during market turbulence. Investing in oil can be a strategy against exposure to loss if the market takes a downturn.
  • Inflation hedging. Commodities have intrinsic value independent from currency, which means they hold their value even as the value of currency falls in an inflationary environment. This is especially true of oil, given the constant and reliable global demand.
  • Speculating. There are often wild swings in commodities prices; investing in oil futures and derivatives is a way to profit quickly from movement in oil prices, which are notoriously volatile. It’s not unheard of for prices to move 5% or 10% in a single trading session. Wall Street speculators aren’t the only ones betting on oil volatility; many major institutional traders buy oil-linked investments for their endowment and pension funds.

Perhaps the most significant advantage of investing in oil is that demand is virtually guaranteed. There may be fluctuations in supply—and therefore price—but there is never a danger that demand will flatline or disappear.

Experienced traders with a high tolerance for risk can make substantial profits on low capital outlays, especially with CFDs, but also with oil ETFs and futures contracts.

And oil commodities have basically zero correlation with other asset classes like equities; they offer protection against losses during periods of turbulence in the market.

The major risk with commodities in general—and oil investing in particular—is the extreme volatility in the market. The risk of loss is high, especially with derivatives, due to factors entirely beyond the trader’s control. It is not an investment for people with risk aversion, and oil investing should be just one strategy in a well-diversified portfolio.

How to Invest in Oil

Investing in oil requires a bit more consideration than other types of assets because there are many product choices you can use to get into the market, from pure-play oil derivatives to oil and gas company equities. Each has its own advantages and set of complicating issues.

Most oil commodities traders will choose one of the following options:

#1 – Trade Oil CFDs

Oil is a global 24-hour market with constantly moving prices; it’s an ideal medium for day traders to profit from fast movement. It’s also a highly liquid market, so it’s easy to get in or out, regardless of the size of the trade.

A “Contract For Difference”, or CFD, is basically a contract between an trader and a broker to exchange the difference in value between when a trade is entered and exited. Standard leverage is usually between a 2% and 20% margin requirement, although lower-end margins are more typical. Contract sizes are usually much smaller than standard futures contracts; the typical crude oil CFD is for 100 barrels (with some firms, you can buy as few as 25 barrels) compared to 1,000 barrels for a standard futures contract.

CFD trades are frequently commission-free (the broker makes his profit from the spread), and since there is no underlying ownership of the asset, there is no shorting or borrowing cost.

Example to explain how CFDs work

Here’s how CFDs work: This is NOT a trading recommendation

You’re bullish on WTI, so you decide to invest in oil CFDs at the quoted price of $60.25 to $60.50 (the lower price is for a short contract, the higher for long).

To buy 10 long CFDs on 3% margin, you would need $1,815 in your account ($60.50 [long price] x 10 [number of contracts] x 100 [number of barrels in a standard contract] x 0.03 [margin percent]). You would then “control” $60,500 worth of oil for your $1,815.

That afternoon, you notice the price is up to $62.50 to $62.75, so you exit the trade, which now has a value of $62,750. You pocket roughly $2,250 on the deal. Of course, if the price ticks down, the degree of leverage works against you rather quickly.

CFDs are complex financial products, they aren’t available in the US and are only recommended for experienced traders. You will not own the oil itself but your capital is at risk.

#2 – Buy Oil Shares

This is perhaps the least complex method of crude oil investing; you simply purchase equities in a company you believe will remain profitable. It’s important to keep in mind that although there is usually a correlation between the price of crude and oil company profitability, this isn’t always the case—and disasters like the BP oil spill can do serious damage to an otherwise solid investment.

Interested in oil stocks? Here are the 5 biggest listed oil companies:

 Current PriceOverviewListingsFoundedNumber of EmployeesInteresting Fact
Sinopec
Chinese oil and gas company based in BeijingShanghai (SSE), Hong Kong (SEHK), New York (NYSE), London (LSE)2000350,000+Largest oil refiner in Asia
ExxonMobil
American multinational oil and gas corporationNew York (NYSE)199980,000+Largest refiner in the World with a capacity of nearly 6m barrels per day
Royal Dutch Shell
British-Dutch multinational headquartered in The NetherlandsLondon (LSE), Amsterdam (Euronext), New York (NYSE)190790,000+Shell have over 40,000 service stations worldwide
BP
Headquartered in London but the USA houses the lion share of its operationsLondon (LSE), Frankfurt (FWB), New York (NYSE)190874,000+Burmah Oil Company, the company that eventually became BP, was the first to discover oil in the Middle East
Total SA
French multinationalParis (CAC), New York (NYSE), Amsterdam (Euronext)1924100,000+Total has over 900 subsidiaries covering all areas of energy

#3 – Buy Oil ETFs

Exchange-traded funds or ETFs are a great way to get a piece of the oil market. You can choose funds that track the performance of oil prices using futures contracts or funds tied to a basket of oil company equities. Here are the 5 leading oil ETFs based on their assets under management:

United States Oil FundiPath S&P GSCI Crude Oil Index ETNProShares Ultra Bloomberg Crude OilPowerShares DB Oil FundProShares UltraShort Bloomberg Crude Oil

#4 – Trade Crude Oil Futures

A futures contract is simply an agreement to buy or sell a quantity of oil at a specified date for a specified price. These are standardized instruments for WTI and Brent that trade on the NYMEX; the standard contract is for 1,000 barrels of oil, so a $1 movement in price is equal to $1,000. Most oil futures contracts require about a 10% margin, which is rather high given the cost of 1,000 barrels of oil, although margins can change depending on volatility—don’t be surprised to get a margin call on oil futures contracts.

Futures contracts are settled by physical delivery of the crude oil, which is something most traders don’t want to deal with, so it’s important to keep track of delivery and expiration dates and either roll the position over another month or close it entirely before the contract expires.

Trading oil futures is typically for professional traders due to the high cost and complexity involved.

Crude Oil WTI Dec ’17:

#5 – Trade Oil Options

With oil options, an trader essentially pays a premium for the right (not the obligation) to buy or sell a defined amount of oil at a specified price for a specified period of time. Crude oil options are the most widely traded energy derivative in the New York Mercantile Exchange (NYMEX), one of the largest derivative product markets in the world

Despite their name, the underlying of these options is not actually crude oil itself, but crude oil futures contracts. Options in the oil market—and the commodities market in general—are more expensive due to the high perceived volatility of commodities prices.

Oil Investment Options Compared

Method of InvestingComplexity Rating (1=easy, 5=hard)Storage CostsSecurity CostsExpiration DateManagement CostLeverageRegulated
Buy Oil Barrels5YESYESNONONONO
CFDs3NONONONOYESYES
Futures5NONOYESNOYESYES
Options4NONOYESNOYESYES
ETFs3YESYESNOYESNOYES
Shares3NONONONOYESYES

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What are binary options?

Binary options limited-risk contracts based on a simple yes/no question about the market’s price action. For example, “Will the price of oil be above $X at 3pm today?”. If you believe the answer to that question is yes then you might buy the binary. If you think the answer is no then you would sell. If at 3pm you’re right you get the $100, if not then you get zero.

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Further Reading

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