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Crude oil is the lifeblood of the global economy and one of the most widely traded commodity markets. In this comprehensive guide, you’ll learn everything you need to know before trading crude oil, including what drives oil prices, the different ways to trade oil, and tips for successful trading.
Crude oil, also known as black gold or petroleum, is a naturally occurring fossil fuel composed of hydrocarbons, organic compounds, and small amounts of other elements. It’s formed from the remains of ancient marine plants and animals that died millions of years ago and were subjected to heat and pressure deep beneath the Earth's surface. Over time, these organic materials transformed into crude oil, which is now extracted through drilling and other methods.
Crude oil is classified into different types based on density and sulfur content. For example, light and sweet crude oil is less dense and has lower sulfur content, making it easier to refine. On the other hand, heavy and sour crude oil is thicker and has a higher sulfur content, requiring more processing to remove impurities.
Crude oil trading refers to buying and selling oil to attempt to generate a return from price fluctuations in the market. Depending on the market participant, there are several avenues traders and investors employ to trade crude oil. This can be done by physically purchasing and receiving the commodity, trading futures and options contracts, investing in oil mining companies and through CFDs, or Contracts for Differences.
Speculators typically engage in two types of markets: spot or futures. Spot markets allow investors to purchase or sell oil at the current market price. At the same time, futures contracts involve agreeing to buy or sell oil at a specified price on a predetermined future date, hence the term futures.
However, speculators aren’t the only participants in oil trading. Corporations, producers, refiners, and more, engage in oil trading to manage risk exposure to adverse price movements. They’re more likely to use complicated derivatives, like options, to help hedge their existing positions.
The oil industry is a vast and complex system broadly divided into three main segments: exploration and production, refining and marketing, and transportation and storage.
Exploration and production involve locating and extracting crude oil from underground reservoirs. Oil companies use advanced technology, like seismic surveys, to identify potential oil fields. Once a viable deposit is discovered, drilling rigs are employed to extract the crude oil from the ground.
The largest oil reserves belong to Venezuela and Saudi Arabia. However, it’s actually the US that leads the world’s oil production, pumping out 18.98 million barrels of oil per day in 2021, according to the US Energy Information Administration.
Refining means converting crude oil into various products like gasoline, diesel, jet fuel, and heating oil. These refined products are then marketed to wholesalers, retailers, and end consumers.
Transportation and storage are essential components of oil production. It plays a key role in moving crude oil and its refined products throughout the supply chain, from oil fields to petrol stations. Both crude oil and refined products are often transported by pipelines, tankers, and rail, requiring a complex network of specialised companies, like pipeline operators and shipping firms, to coordinate and facilitate timely delivery.
Brent and West Texas Intermediate (WTI) are the two most widely traded and recognised crude oil benchmarks in the world, serving as a reference point for global oil prices.
Brent crude oil, named after the Brent oil field in the North Sea, is a blend of crude oils from various fields in the region. The North Sea is also a key area for producing other energy sources, like natural gas and wind.
Brent is a light, sweet oil, making it easy to refine into petrol and other valuable products. It’s a benchmark for the African, European, and Middle Eastern crude markets, which comprise around two-thirds of global oil production. Brent crude oil futures contracts trade on the Intercontinental Exchange (ICE).
WTI refers to crude oil extracted in the US, predominantly in Texas, but also in many other states, like North Dakota. It’s also a light, sweet oil but is considered slightly higher quality than Brent. WTI provides the benchmark for all crude oil produced in the Americas. WTI futures contracts are traded on the New York Mercantile Exchange (NYMEX) division of the Chicago Mercantile Exchange (CME).
Crude oil prices are affected by a wide range of factors that can cause them to fluctuate significantly over time. Let’s look at five of the major drivers of crude oil markets.
Like all tradeable instruments, crude oil prices are largely determined by supply and demand. Global oil consumption generally rises when economies grow since oil-intensive goods and services production increases when consumers are better off. Likewise, production levels, adverse weather, and technological advancements can affect the supply of crude oil.
For example, at the start of the Coronavirus pandemic, the price of oil fell dramatically as market participants anticipated a steep decline in demand. As economies reopened, oil prices rose to reflect the rebounding demand.
Crude oil prices are highly sensitive to geopolitical events, such as wars, civil unrest, and diplomatic tensions, particularly in major oil-producing regions. These events can disrupt oil production and transportation, leading to supply shortages and price spikes.
Macroeconomic factors, such as GDP growth, inflation, and interest rate decisions, can affect crude oil prices by influencing global economic activity and, consequently, demand for oil. Additionally, fluctuations in currency exchange rates, particularly the US dollar, can impact oil prices since crude oil is primarily traded in US dollars, known as petrodollars.
Weather events, such as hurricanes, storms, and extreme temperatures, can disrupt oil production, refining, and transportation infrastructure, leading to temporary fluctuations in supply. For instance, freezing temperatures disrupted oil production in Texas and North Dakota in late 2022, which helped to push crude oil markets higher.
The Organization of the Petroleum Exporting Countries (OPEC) is a powerful cartel of major oil-producing nations that can influence global oil prices by coordinating production policies among its member countries. OPEC's decisions on production quotas, output cuts, or increases can significantly impact the price of crude oil.
Trading oil offers the potential for returns but also involves inherent risks that traders must manage effectively. Here are some of the most important risks and rewards to be aware of when trading oil.
Risks:
Spot trading involves buying or selling crude oil at its current market price.
Oil futures contracts are agreements to buy or sell a specified amount of oil at a predetermined price on a future date. Traders can buy or sell these contracts on commodity exchanges, like the New York Mercantile Exchange (NYMEX).
Many oil traders gain exposure to oil prices through CFDs. CFDs allow traders to speculate on the price movements of crude oil without owning the underlying asset and enable them to go both long and short. Like futures trading, CFDs are leveraged instruments. However, contract sizes are often much smaller than standard futures contracts.
Trading in the oil market can be both rewarding and challenging. To increase your chances of success, there are a few aspects of the oil market to be aware of.
As discussed, news like OPEC decisions, geopolitical events, and regulatory scrutiny can influence oil prices. Finding a mix of factual and opinion-based reporting may help to expand your knowledge in the crude oil sector and help you keep up to date with the latest crude oil market events.
One of the most impactful news releases is oil inventory reports, such as those released by the US Energy Information Administration (EIA) and the American Petroleum Institute (API). These reports provide insight into the supply and demand dynamics of the oil market and can impact prices.
The oil market tends to exhibit seasonal patterns, with demand typically increasing during the winter months due to heating needs and also rising during the summer months as a result of increased travel. Understanding these patterns can help you identify where the market may be headed next.
Technical Analysis:
Through analysing historical price action, trading and investors can forecast future price direction in the oil market. Traders often blend technical and fundamental analysis to generate trading and investing decisions.
Now that you have an understanding of the oil market, consider opening a demo Trading Account with FP Markets. Offering both Brent and WTI CFDs, FP Markets is a leading Forex and CFDs brokerage known for award-winning 24/7 customer support and fast execution.
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