The world of natural resources
The energy sector of commodities is dominated by one resource – oil.
Indeed oil is such a dominant force in this sector that it distorts the commodity indices which give us a view on the performance of the market as a whole. As an example, in the S & P GSCI index of 2010, energy represented almost 70% of the index, with the next largest being agriculture at 15% followed by industrial metals and precious metals which when combined represented just over 10%.
Within the sector there are of course many other commodities, including natural gas, coal, and refined oil products, but crude oil dominates the sector since it is the single commodity which currently powers the modern world.
Crude oil comes in a variety of qualities and is generally categorized by reference to its density, which then appears as either heavy or light in the futures contract specification, and its sulphur content. A low sulphur content crude is referred to as sweet, whilst a high sulphur content crude is referred to as sour. As a general rule, a light sweet crude will command a higher price than a heavier sour crude since it is easier and cheaper for refiners to extract high value products from the light sweet oil.
One of the most significant changes in the energy futures markets occurred in 2008, when the NYMEX group was merged into the CME group which effectively unified energy trading along with the other broad sectors on the CME exchange. Most energy futures trading is now executed on the CME Globex electronic platform having moved away from the pit and open outcry. Many of these contracts do still call for physical delivery, so futures contracts need to be selected with care.
The economics of oil
There are only two facts of which we can be certain when considering the economics of crude oil.
- First, the supply will eventually run out.
- Second, demand for oil and its associated refined products will continue to rise in the short to medium term, and will only start to decline once alternative energy sources become a viable option and which eventually replace oil as the resources begin to decline.
Just like oil, the supply and demand curve for crude oil is far from simple, since it is a unique commodity in every sense of the word, and in the short term, both supply and demand are highly inelastic. Supply and demand elasticity governs most major markets and commodities, since a rise in price will generally result in a fall in demand, whilst a fall in price will result in a rise in demand. This is certainly not the case with oil. From a demand perspective, if the cost of fuel rises, then you continue to fill your tank with gas, as you have no alternative, other then to move to an alternative car with a different technology. An expensive and impractical decision. So you continue to buy gasoline at the prevailing, and ever rising prices. Similarly you will continue to heat your house in the winter and simply pay the increasing costs of doing so.
Equally the supply side of the equation is also inelastic but for different reasons. Firstly, the cost of entry to the market is extremely high, effectively limiting the type of company able to enter and compete in the market. Secondly, the actual cost of pumping an extra barrel of oil is relatively low, so the cost of operating and maintaining an oil field will be much the same whether oil is being produced at 60% capacity or at 100% capacity. So there is virtually no reason for an oil field to operate under capacity, and therefore most will operate at their maximum at all times.
Now, whilst short to medium term supply and demand is inelastic, the longer term scenario is very different. Each time there is a major shock in the oil market( such as in the 1970’s with the war in Israel )this simply shifts the supply demand relationship slightly. In other words, the knee jerk reaction is to look for alternative sources of energy, with each major event sowing the ultimate seeds of destruction for oil. Indeed the recent spike in oil in 2011, which saw crude oil touch $147 per barrel before reversing low, is yet another such event which will have driven consumers and manufacturers to develop new and more efficient energy sources, both for industry and the consumer.
In addition to the natural and man made events which shape the oil market, there is one other key player, which is OPEC. Originally established in 1965 to protect the interests of the oil rich net exporters of oil OPEC continues to operate as a price cartel regulating supply into the markets from it’s member states.
All of this makes forecasting the future price of crude oil extremely difficult if not impossible, since there are so many competing factors. Fundamental, political and economic factors all combine into a single price chart for oil.
Weekly EIA oil stats
Each Wednesday in the US, the EIA,(the Energy Information Administration) releases its report on whether oil inventories have increased or decreased in the previous week. In simple terms it indicates if there has been a net build in stocks or a net draw. The headline number is generally quoted millions of barrels, and below is an extract from a recent report.
The market reaction to these releases is generally seen both in the price of crude oil itself, along with associated ‘’commodity currencies’’ such as the Canadian dollar. Canada is a net exporter of oil, and is now developing the Alberta sands oilfields which have the potential to exceed the oil reserves currently in Saudi Arabia.
Benchmark oil futures contracts
There are essentially two primary qualities of oil, and therefore two benchmark oil contracts. They are the WTI (West Texas Intermediate) crude oil at the Cushing hub in Oklahoma, and Brent crude. WTI crude oil is a high quality oil, produced, as the name suggests, in the South Western states of the US and normally referred to as WTI light sweet crude. Brent crude oil on the other hand is a blend of crude oil produced from a variety of different offshore oil fields in the North sea and as such has a lower gravity and a higher sulphur content. Brent crude was first traded in London on the International Petroleum Exchange which was subsequently acquired by the ICE exchange in 2005.
Both of the above are now available on the CME and historically the WTI contract has traded at a premium over the Brent contract typically by one or two dollars per barrel due to it’s higher quality and preferred refining characteristics, and is therefore the benchmark against which all oil prices are pegged. However, this is not always the case, and local changes in supply and demand can reverse this relationship from time to time, as happened in 2007 when Brent traded above the WTI contract for an extended period.
The benchmark NYMEX crude oil futures contracts call for delivery of 1,000 barrels of WTI oil at the Cushing hub, and are quoted monthly. The contract is quoted in dollars and cents per barrel with minimum increments of $0.01 per barrel, the equivalent to $10 per tick. However, as with many other futures markets, the CME along with other exchanges have introduced a range of mini futures contracts, and for the CME this is quoted at half the size of a full contract (or 500 barrels.)
So who trades energy?
The energy markets are of course driven by supply and demand for oil, one of the world’s most basic resources, and as such, a substantial percentage of trading in the energy futures markets, is between buyers and sellers of the physical commodity. However, as with many other commodities, the large exchanges such as the CME have recognised the increasing demand from the small trader and speculator to trade in the more popular markets such as oil, and have therefore introduced a range of smaller contracts along with electronic trading.
Why should you trade trade energy?
Just like gold, oil is one of the most liquid markets, and now traded on a 24 hour electronic basis, making the market accessible to traders around the world, and not restricted to the times dictated by a physical exchange. The CME now has an several E mini contracts in the most popular energy commodities, including WTI light sweet crude, natural gas and heating oil, so there is no longer any reason to hold back from this market. These contracts are small, and have been designed to help the smaller trader or speculator get started, and begin building their knowledge and experience with contracts which are generally 50% of a full size contract.