Wars have been fought over it and nations desperately jockey to pillage the Earth of it: oil is Mother Nature’s densely packed energy storage sludge.  This sludge, however, is so valuable that many consider it an indicator of the overall health of an economy.

A high crude oil price is worrisome because it shrinks businesses’ profits and triggers higher inflation.  For consumers, the oil price affects our daily lives in many ways: what we pay at the pump, at the supermarket, or for airline tickets.  Some items are affected directly, such as gasoline or heating oil, others are affected indirectly by an increase in their transportation costs.

Supply and Demand

A report published by the US Energy Information Administration (EIA) lists the many complex factors that contribute to oil price fluctuations.  The traditional ones are supply and demand.  The landscape of the oil market is unique, as both supply and demand are polarised and have unique characteristics and needs. The oil supply is represented by:

•    OPEC (Organization of Petroleum Exporting Countries) that produce 40% of the world’s oil production. OPEC’s production is concentrated in the hands of few government-owned and operated companies. OPEC is an organisation whose purpose is to control supply by establishing production quotas for each member country. The end goal is to influence oil’s price. How well the quotas are actually implemented is a debatable subject.

•    Non-OPEC (Canada, USA, Mexico or Russia among other countries) is responsible for the rest of the production (60%).

Demand can also be divided into two categories:

•    OECD (Organisation of Economic Cooperation and Development) - which includes the USA, Australia, most European countries and other advanced economies - is responsible for 53% of oil consumption.  However, oil consumption growth for OECD countries increased at a slower rate relative to those of developing countries during the last decade.  There are a few reasons for this lethargic trend: slower growth, more energy-efficient motor vehicles, and the fact that OECD consumers are more sensitive to changes in oil prices because of they do not receive subsidies from the government. Therefore, they tend to consume less when the oil price rises.

•    Non-OECD countries (for example China, India and Saudi Arabia) have been the engines for demand growth in the last few years – their domestic demand increased by about 40%.

The other factors that influence oil are inventories and financial markets.  Inventories are important because we need to know how much surplus is available in case of a supply disruption. The oil financial market is influenced by two categories of participants:  

•    Physical participants (producers, merchants or processors) who tend to be net short on the futures contract, since they are going to sell the crude oil in the future and wish to hedge against falling prices.

•    Speculators (individual traders, money managers and investment banks) who tend to be net long on crude oil future contracts, according to the US Commodity Futures Trading Commission’s (CFTC) weekly reports.

Since speculators tend to buy contracts and drive up the price of crude oil, many have wondered about the socio-economic consequences of speculation.  This is why hedge fund manager Michael Masters testified in front of the US Congress in 2008.  His argument was that the crude oil price spike in 2008 was not the result of a supply disruption, unlike the causes of the 1973 Arab Oil Embargo crisis. The culprits this time are “Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.” The numbers are very compelling: speculative investments “have risen from $13 billion at the end of 2003 to $260 billion as of March 2008, and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years.” Below is a chart that shows the distribution of speculative money among commodities markets:

As you can see, energies make up about 34% of the pie, and the first three speculative commodities of choice are crude oil, natural gas and gold.

All right, you may say, why should I care about the price of a crude oil contract traded on NYMEX if I live in Melbourne, Australia?  Although it is true that there five different types of crude in the world – WTI (West Texas Intermediate), Brent, Mars, Tapis and Dubai - their prices have moved in the same direction due to arbitration, even though they have different quality and are traded at different locations—the only ones that are traded on exchanges are WTI on NYMEX (New York Mercantile Exchange) and Brent on ICE (Intercontinental Exchange) Futures Europe.

Beyond Supply & Demand

Hang on…there is more. The price of oil is also influenced by

•    Political events - meaning that political uncertainty brings increases in volatility.  Anything from comments made by Venezuelan president Hugo Chavez, or Iranian president, Mahmoud Ahmadinejad, to the Libyan conflict has impacted the price of oil.

•    Extreme weather events, such as 2005 hurricane Katrina in the Gulf of Mexico or this year’s flooding and cyclones in Australia

•    OPEC announcements regarding increasing or decreasing the output

•    IEA (International Energy Agency) projections and also

•    EIA weekly reports regarding available stockpiles

The most important events in the last 30 years and their impact are very nicely put together by the EIA on the chart below.

Australia & Oil

According to The Oil and Gas Journal (OGJ), Australia had 3.3 billion barrels of proven oil reserves as of January 1, 2010, more than double the 2009 estimate of 1.5 billion barrels. Australia’s oil reserves are located primarily in Northern and Western Australia.  Although Australia produces a significant quantity of oil, it is not enough to cover its own usage, and it is expected that Australia’s dependence on oil will increase dramatically, along with the nation’s petroleum trade deficit. Therefore in coming years, Australian imports from Vietnam, Malaysia, Indonesia, United Arab Emirates and Papua New Guinea are expected to increase.  (See chart below)

Trading

There are many ways that you can trade crude oil.  You may trade it via futures or options contracts by opening an account with MF Global, IG Markets and others. 

Alternatively, you could trade it via CFDs (Contract For Difference).  Most Forex brokerage houses such as FXCM, MF Global, and IG Markets, allow their customers to trade CFDs for major global commodities: oil, natural gas, gold and silver.  Some brokers even offer local and online seminars on CFD trading. 

The third way to get your feet wet is by purchasing shares of the companies directly involved in oil production or transportation.  The largest Australian oil companies traded on ASX are Woodside Petroleum (WPL) and Santos (STO). 

ExxonMobil is the largest foreign oil producer; other international oil companies include Shell, Chevron, ConocoPhillips, Japex, Total, BHP Billiton, and Apache. 

The other important players in this industry are pipeline operators, such as Australian Pipeline Trust (APA), which has 6,200 miles of pipeline, the largest company of its kind in Australia.

Recent Developments and Projections

On June 23, 2011, IEA member countries decided to release some of their petroleum reserves to put a lid on oil prices, since OPEC failed to agree on increasing output.  In response to this release Goldman Sachs wrote a bearish mid-term forecast for Brent oil:

“We estimate that a 60 million barrel release by the end of July has the potential to reduce our 3-month Brent crude oil price target by $10-12 per barrel, to $105-107 per barrel. We would expect the release to have less of an impact on prices further out the curve, as the oil would be absorbed to meet current demand.”

Is Goldman right?  Take a look at crude oil’s daily chart (NYMEX: symbol CL) and it’s relationship with 10-day SMA and 20-day EMA and judge for yourself!

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