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How to Trade Crude Oil?

How to Trade Crude Oil?

The oil industry produces more than four billion metric tons of crude oil each year, of which about a third is contributed by Saudi Arabia. According to the IEA, the global demand for oil is expected to reach 1.4 million barrels per day (bpd) in 2019, a rise from the 1.3 million bpd in 2018.

As of 2019, the United States surpassed Saudi Arabia and Russia to become the largest crude oil producing nation in the world. This means that any event related to the US economy will have a ripple effect on the world’s crude oil prices.

Crude oil is one of the most popular commodities to trade, given that its market is extremely active, with even the tiniest news leading to price fluctuations. This offers multiple trading opportunities, especially for swing and day traders.

What You Should Know Before Trading Crude Oil

As you would with any other asset, familiarising yourself with the basics of the crude oil market gives you a strong foundation for trading. Here are some things you should know:

Oil Spot Prices

These prices provide information on the cost of purchase or sale of oil, and taking delivery “on the spot” or immediately. This is in contrast to oil futures, which represent the estimated value of oil at the end of a predetermined period of time in the future.

Types of Crude Oil

There are different grades of physical oil that are traded across the world. The two main crude oil grades are West Texas Intermediate (WTI) and Brent North Sea Crude, which is known as Brent Crude. Brent Crude has a sulfur content less than 5% (at about 0.37%).

Brent is mainly produced in the North Sea and other Brent oil fields. Its price is the benchmark for European, African and Middle Eastern crude oil. Brent prices control the value of about two-thirds of the crude oil produced globally.

WTI, on the other hand, forms the benchmark for crude oil prices in North America. It is produced in the United States, as the name suggests, and is a combination of a number of light, sweet oils.

While Brent is better suited for the production of fuels, WTI is used mainly for the production of gasoline.

Cost of Crude Oil

The cost of crude oil usually ranges from $3 to $4 per barrel for shipping to the United States from Europe. The cost of storing crude oil is different in the North American and European trading hubs. The price difference between WTI and Brent fluctuates between $2.5 to $4.

Trading Crude Oil

You can participate in the crude oil market in several ways:

1.    Futures

Here, two parties enter into an agreement, known as a futures contract, to buy or sell a specific quantity of crude oil at a predetermined future date, at a pre-decided price. Both Brent and WTI are traded via such contracts on the NYMEX, with a standard contract being for 1,000 barrels. This means that every $1 move in the price would lead to a gain or loss of $1,000. These contracts are settled through the physical delivery of the oil barrels, which might not be something that traders want to get into. So, one will have to closely follow the expiration date of the contract and either roll over the contract for an additional timeframe or close the contract before it expires.

2.    Options

Similar to futures contracts, in that here too the trader pays to gain the right (although not the obligation) to sell or buy a specific quantity of oil at a pre-decided price and for a pre-determined timeframe. This is the most commonly traded energy derivative on the NYMEX, which is among the largest derivatives markets globally. Being a derivative instrument, you don’t actually buy or sell crude oil but the futures contracts. However, crude oil options tend to be expensive.

3.    Shares & ETFs

If you don’t want to deal directly with the commodity, you can still participate in the market by investing in stocks of oil companies, as well as crude oil ETFs. Share prices of oil companies are significantly impacted by oil prices and, therefore, offer trading opportunities with fluctuating prices. For those with a low risk appetite, investing in exchange traded funds or a basket of stocks belonging to the oil industry may be a good idea.

4.    Contracts for Difference

This is one of the easiest ways to participate in the crude oil market. A contract for difference (CFD) is an agreement between two parties to exchange the difference in value of an asset between the start of the contract and its close date. Here, the trader enters into an agreement based on their estimation of where the prices of oil futures and options are headed through the tenure of the contract. You can also trade WTI and Brent spot prices via CFDs. Both long and short positions can be taken, based on whether you expect the market to be bullish or bearish. Moreover, the contract sizes are much smaller than futures contracts, although brokers do offer leverage to enter into larger contract sizes.

Trading Tips to Keep in Mind

Just like trading forex, commodities trading also requires a good umderstanding of technical analysis, fundamental analysis and effective risk management.

Why Fundamental Analysis?

The key influencer of crude oil prices is the usual supply and demand equation. So, anything that alters the balance between supply and demand will lead to price fluctuation. Geopolitical factors play a crucial role in supply and demand. Anyone who drives a car knows how acts of war, terrorism, trade sanctions and coups can send oil prices sky rocketing.

In addition, oil prices follow a seasonal pattern, with crude oil prices tending to rise in August and dipping around September-October. In addition, weather conditions in the largest oil producing regions also influence supply, such as hurricanes in the Gulf of Mexico. So, following seasonal trends can be useful for making informed trading decisions.

Did you know that crude oil prices are strongly correlated with the strength of the US dollar? When the US dollar rises in value, crude oil prices tend to decline and vice versa. So, you can actually get a quick idea of the strength of the former from the value of the latter. Of course, this is only an indication and should not be the basis of a trading decision.

For effective fundamental analysis, it is useful to keep track of crude oil output and consumption forecasts. Here’s a look at some other reports that you should track to stay informed.

Reports Every Crude Oil Trader Should Follow

Weekly updates about oil inventories in the US are an extremely important piece of news for oil traders. This inventory data is a crucial measure of global crude oil demand. For instance, if the crude oil inventories rise, it usually indicates a decline in demand and vice versa.

To stay updated on inventory status, two weekly reports are important:

  1. The Department of Energy Report: This report offers information regarding crude oil and refined products inventories. It is released every Wednesday at 3:30 pm GMT.
  2. American Petroleum Institute Report: This weekly report contains data about the most crucial petroleum products that form about 80% of the refinery production and crude oil inventories. It is released every Tuesday at 9:30 pm GMT.

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