Like most commodities, trading oil can seem as simple as weighing up the supply and demand to predict where future prices will head. Falling production and rising demand pushes prices higher, while increasing production twinned with softer economic growth tends to push them lower – but gaining the full picture and understanding what it means at other times (like when output and demand are heading in the same direction) requires a lot of research and some reading in-between the lines.
Brent vs WTI crude oil
There is more than one type of oil being extracted out of the ground, which requires different benchmarks to be used. The key characteristics that separate one type of oil from another include its API gravity (its density compared to water) and how ‘sweet’ or ‘sour’ it is (the amount of sulphur content or impurities, with sweet crude containing less than 0.5%).
Brent and West Texas Intermediate (WTI) are two of the most widely traded oil benchmarks in the world. Brent accounts for oil produced in the UK North Sea (and is named after the Brent discovery made in 1971) while WTI, as the name suggests, refers to the oil being extracted in West Texas and other states including Louisiana and North Dakota. Brent is a heavier oil compared to WTI and although it is still classed as sweet, it does contain higher sulphur levels than WTI. Still, both are ideal for refining into petrol and other products.
Together, they act as global benchmarks for the price of different types of oil produced in various geographies. Brent acts as the benchmark for most of the oil produced in Europe, Africa and some of the Middle East while WTI represents production across North America, particularly US shale.
Today, Brent is the most widespread marker, used as a benchmark price for up to two-thirds of all crude oil traded globally, and demands a slight premium to WTI. However, WTI only demands a lower price because the cost of extracting US shale has dropped considerably relative to the costs of extracting oil from deep underwater in the UK North Sea over the last decade.
What drives oil prices?
At the most basic level oil prices are driven by a combination of supply, demand and speculation – all of which need to play a part in any comprehensive trading strategy. Five basic elements to keep in mind are:
- Production/new supply: the amount of new oil being produced
- Demand/economic growth: the demand for oil and changes in economic growth
- Inventories: the amount of oil that is held in storage
- Capacity: changes in capacity of pipelines, refineries and other important oil infrastructure
- Speculation: how the futures market prices oil based on future projections and all the considerations above
Oil trading strategies using the futures market
Oil futures are contracts to purchase a certain quantity of oil in the future at a price that is agreed today. The hope of the buyer is that the price they pay is lower than the spot price when the contract ends, while the seller hopes the price they sell for is higher than the spot price. Either way, both have protected themselves.
This means the futures market provides an insight as to where the participants of the futures market – largely oil producers, hedge funds and commodity traders - think the oil price is headed as they are essentially speculating what the oil price will be in the future.
The share prices of oil companies react to movements in the oil price, as this changes the value of the primary assets (the oil) that underpin the business. However, many energy and mining companies use the futures market to try to hedge against potential price falls by locking in prices for future production, which in theory should also help protect them from the swings in the price of oil. Those stocks that don’t participate in the futures market are therefore more exposed to movements in the spot price of oil.
Oil trading using fundamental analysis
All of these drivers can be influenced by an endless list of factors. Production can be hampered by countries being placed under international sanction or could rise if large groups of nations agree to raise output. Weaker gross domestic product (GDP) growth or weaker sales of petrol-powered cars can lower demand. Inventories can dwindle when production declines and rise when companies look to hoard their barrels in the hope of selling them at a later date when prices are higher. Capacity can change if new pipelines are brought on or tighten due to militia attacks or leaks. And the sentiment toward future oil prices can swing from bullish to bearish, or vice-versa, very easily as traders take in and react to the constant stream of data and news flowing from the market.
Although data and reports on the international oil market play a key role in helping us understand the state of play at a global level the most important data is released at a regional level that investors must combine to gain a true picture of where the oil market – and the price – is headed. Saudi Arabia, Russia, the US, Canada and China are among the biggest producing countries in the world and it is important to understand the state of relations between them, as well as the conditions in other important producing regions in the likes of Africa.
Analysing the oil market also goes beyond tracking supply and demand. To predict where oil prices are going over the longer term requires investors to dig deep into other data such as the amount being invested in finding and developing new resources to understand supply over the longer term, or how major shifts such as the one to cleaner energy will weigh on demand over future decades rather than years.
With so much to consider we explain what data oil traders should track and the most important points to take into account when forming an oil trading strategy.
The role of US shale in oil trading strategies
Arguably the biggest change to have occurred in the global oil market over the last decade is in the shift of supply coming from the US. Fracking for shale oil has exploded since 2010: having returned to over ten million barrels per day for the first time since the 1970s, and having sunk to a low of around four million barrels at the time of the financial crisis. That has seen the US move into the top producers in the world and rival Saudi Arabia, which had long used its dominance of the oil market in its political wrangling with western governments. The latest data shows the gap at the top is tight, with Saudi Arabia, Russia and the US having all increased production this year to around 10.5 million barrels per day each. The US, having never exported more than 14,000 barrels of oil per month, is currently exporting a record amount of crude oil – over 66,000 barrels in July 2018 according to the Energy Information Administration (EIA), from below 3000 barrels just five years ago.
US data is therefore a vital tool to use when forming an oil trading strategy:
- EIA crude oil stocks change: the EIA measures the change in the number of barrels held in inventory by US companies on a weekly basis. The EIA requires US companies to accurately report their inventory levels. These reports are often compared to expectations: if the rise in inventories if more than expected or a fall is less than anticipated then this is often a sign that demand is weaker than what the market forecast. If inventories rise less than what was expected or decline at a slower rate than forecast then this signals that demand is weaker than what the market expected.
- API weekly crude oil stock: the American Petroleum Institute (API) reports the inventory levels of US crude oil, petrol and distillate stocks on a weekly basis, showing how much oil and refined products are being held in US storage. Although the API claims high engagement with the industry, the numbers are provided by companies voluntarily so therefore it is considered less accurate than the data released by the EIA. However, traders use both to gain a more detailed view of the market and so they can spot any large discrepancies between the two.
- Baker Hughes US oil rig count: this tracks the number of rigs in operation in the US on a weekly basis and is a vital barometer for the drilling industry and its suppliers. This provides an insight into demand for the equipment used to drill for oil as well as the level of activity taking place. If rig numbers fall then that would imply production in the future will fall, and growing rig numbers suggest production would rise. Baker Hughes also counts rigs in Canada and estimates the level of activity on a global scale. Other firms such as Platts also offer similar readings.
The role of OPEC in oil trading strategies
The Organisation of Petroleum Exporting Countries (OPEC) was set up in 1960 and is a consortium of some of the largest exporters of oil in the world. Modern-day OPEC has 15 member states that collectively account for about 40% of world production, having ceded a share to US drillers over the last decade. The organisation still, however, holds around 60% of the world’s total resources.