Arguably, crude oil is the most important commodity today. It impacts every single economy and every single person in the world. It is hard to imagine how our world would have evolved without the advent of crude oil. In the simplest terms, crude oil is nothing but unrefined petroleum. It is a blackish-yellow liquid that is found in specific geological regions deep underneath the surface of our planet. When drilled, extracted, and refined, several products can be made from crude oil such as gasoline (i.e. petrol), diesel, jet fuel, heating oil, asphalt, and various other petrochemicals. Unlike metals which can be reused again and again, crude oil cannot be reused. It is a non-renewable source of energy
Crude oil is a naturally occurring element that was formed by the decomposition of plants and animals which died millions of years ago. The remains of these plants and animals were trapped at the bottom of the water body (such as an ocean) within layers of sedimentary rocks where they were subjected to enormous heat and temperature. Eventually, over a course of several millions of years, this entire process led to the formation of crude oil.
Crude oil is not only the most used commodity worldwide, but it is also the most traded commodity. The two most popular grades of crude oil that are traded in the financial markets are the West Texas intermediate (WTI) crude oil and Brent crude oil. While WTI is the US benchmark oil that is traded on the NYMEX (New York Mercantile Exchange, US) platform, Brent is often considered the global benchmark oil and is traded on the ICE (Intercontinental Exchange, Europe) platform. In India, crude oil derivatives is most traded on the MCX. Recently, NSE has also started to offer trading in crude oil derivatives.
Nearly 60% of the demand for oil comes from the transportation sector, wherein it is used to fuel the various modes of transportation i.e. road, rail, water, and air. Within the transportation sector, nearly 80% of demand is consumed by vehicles on road, while the remaining 20% is consumed by rail, air, and water. Until now, there have been very few alternative sources of fuel available for transportation. Most of the fuel that is used for transportation purposes is a product of crude oil such as gasoline, diesel, and jet fuel. While gasoline is usually used to power light vehicles such as motorcycles, cars, and small trucks, diesel is usually used to power heavy vehicles such as buses, trucks, and trains. Meanwhile, jet fuel is used to power airplanes and helicopters.
The second major source of oil demand is the industrial sector, which accounts for over 25% of the total demand for oil. Within the industrial sector, half of the demand for oil comes from petrochemical industries. As the name suggests, petrochemical industries are industries that produce chemicals from petroleum products. These chemicals are then used to manufacture thousands of industrial and consumer products that form an essential part of our day-to-day lives. Examples include plastics, paints, tyres, fibres, fertilizers, clothing, detergents, packaging, and textiles. The rest of the demand for oil from the industrial sector comes from all other industries, where oil forms an essential component of various manufacturing activities
The remaining one-sixth of thedemand for oil comes from sectors other than transportation and industries. Within this sector, two-third of the demand comes from residential, commercial, and agricultural sector, while the remaining one-third comes from electricity generation. Besides being used to fuel vehicles and for industrial applications, crude oil also has other important uses. For instance, during winters when the temperatures drop significantly in some countries, heating oil, which is a product of crude oil, is used in homes and other places to feel warmer. The availability of such fuel makes it possible for humans to survive in places that are extremely cold. Meanwhile, some countries also use crude oil in order to generate electricity and power their economies.
There are various grades of crude oil, depending on oil’s physical properties and chemical composition. Broadly speaking, crude oil is classified on the basisof two things. One is the density (or thickness) and other is the sulphur content. Depending upon density, crude oil can be classified as either light or heavy; while depending on the sulphur content, crude oil can be classified as either sweet or sour.
Crude oil is considered light if it has a high API (American Petroleum Institute) gravity, and it is considered heavy if it has a low API gravity. The API gravity measures the weight of oil relative to that of water. Light oil weighs less than water and hence it floats on the surface of the water; while heavy oil weighs more than water and hence it sinks and settles at the bottom of the water. Light oil is thin and is easy to move through oil pipelines. Heavy oil is thick and does not move easily. Because of this, heavy oil often needs to be processed more before it can be moved via pipelines.
Crude oil is considered sweet if it has a low sulphur content, and sour if it has a high sulphur content. Oil that issour needs to be processed more in order to reduce the quantity of sulphur in it. This is because sulphur can harm humans and the environment. Furthermore, sulphur is corrosive, meaning greater amounts of sulphur can harm refineries and therefore increase their maintenance costs. Because of all these undesirable characteristics, sour crude oil needs to undergo additional processing before it is sent to refining.
Light, sweet oil require little processing as compared to heavy, sour oil. Also, per barrel of oil, light, sweet oil yields a greater amount of high-value end products such as gasoline. Because of these benefits, light, sweet oilis usually priced higher and are more valued. Heavy, sour oil, on the other hand, can also yield gasoline. However, heavy, sour oil needs to undergo a lot of processing to remove impurities before it can yield high-quality end products such as gasoline.The costs that are associated in doing this usually outweigh the benefits. As such, for making high-value products, refiners usually prefer light, sweet oil. Instead, heavy, sour oil is usually used to make middle to heavydistillates such as diesel fuel.
Having said that, the type of crude oil that refineries buy also depend to a great extent on the type of machineries that they have. In other words, if a refinery is configured to process heavy, sour oil, then it will buy heavier grades of crude oil rather than lighter grades to make various end products, and vice versa. A good example of this is refineries in the US Gulf Coast (USGC), a lot of which are more suited to processing heavy, sour grades.Given the way these refineries have been configured, they still must rely on importing heavy, sour oil from other nations for producing various refined products. This is despite the US producing record quantities of high-quality light, sweet crude oilpost the shale boom that started last decade.
There are hundreds of different grades of crude oil that trade around the world. In this section, we will talk about some of the most important grades of crude oil which must be eyed upon. These are as mentioned below:
West Texas Intermediate (WTI) oil is the benchmark grade in the US and is one of the most tracked oil price around the world. WTI is a high-quality light, sweet crude oil that is produced predominantly in the Texas basin and delivered at Cushing from where it is transported to various refineries in the US for refining and exporting. The financial derivative instrument of WTI oil is traded on New York Mercantile Exchange (NYMEX) and is one of the most liquid commodity derivative contract around the world.
Brent oil is produced in North Sea, situated in Europe,and comprises of 4 blends that is commonly abbreviated as BFOE, which stands for Brent, Forties, Oseberg, and Ekofisk. Brent oil is classified as light, sweet crude oil. However, it is not as light and as sweet as WTI oil is. It is traded on the Intercontinental Exchange (ICE) and along with WTI, is one of the most watched after crude oil price. Brent oil is used as a reference price for various grades of crude oil around the world
The OPEC basket is the benchmark price for various grades of crude oil that are produced by members of the OPEC cartel. It is calculated as the weighted average of the oil prices of each member of the cartel. Given that OPEC production accounts for around 40% of the global production and that OPEC exports account for around 60% of the global oil trade, the OPEC basket is closely tracked by a lot of countries around the world who import oil primarily from the OPEC.
Dubai grade refers to crude oil that is produced in the United Arab Emirates (UAE). It is medium-sour in quality and is one of the very few grades that is available for spot trading. It is an important benchmark, especially for the pricing of Middle Eastern Gulf grades in Asia.
Western Canadian Select (WCS) oil is the benchmark grade of Canada. It is a very heavy, souroilderived from bitumen (a thick and sticky form of crude oil) and produced in the Hardisty province of Alberta. Most of the Canadian oil is exported to the refineries in the US, particularly in the Gulf Coast because of their ability to handle heavy blends. The reason why Canadian price is tracked is because the US is the largest importer of Canadian oil. As such,any significant disruptions from Canada can influence prices in the US too, especially those of the heavy grades.
Urals oil is the benchmark grade of Russia, the world’s second largest oil producer. It is a mixture of heavy-sour grades of the Urals region and light-sweet grades of the Western Siberian region. It is often used as a benchmark for the medium-sour grades in Europe. Most of it is exported to several countries across Europe and in China, thereby making it an important grade. As a lot of Russian oil flows into Europe, the price of the Urals grade is closely impacted by that of Brent. Because Urals is a medium-sour blend, it is usually priced below that of Brent.
Crude oil is a giant commodity. Its price impacts virtually every person on this planet. A rise in oil price benefits oil exporters, because it translates into a higher revenue for these nations. However, it has a detrimental impact on those nations that rely heavily on oil imports to meet their demand. Given that oil forms a significant portion of any importing nation’s trade bill, a rise in oil price would not only worsen their trade balance situation (and thereby put pressure on the nation’s currency), but it will also lead to a rise in inflationary pressure. A fall in oil price, on the other hand, would have an opposite impact i.e. it will negatively impact oil exporters and benefit oil importers.
Crude oil has a significant impact on the health of the global economy. In fact, post the World War 2, every recession in the US has been preceded by a surge in the price of crude oil. In this section, we will talk about some of the major factors that impact the price of crude oil
As per US Energy Information Administration (EIA), world oil production averaged 82.8 million barrels per day (mbpd) in 2018. This reflects the total oil produced by both OPEC and non-OPEC countries, which had a market share of 41% and 59%, respectively. The top five oil production nations in 2018 were the US (13.2%), Russia (13%), Saudi Arabia (12.6%), Iraq (5.6%), and Canada (5.2%).
As can be seen, these five nations account for half of the global output. As such, any marked changes in the supplies of these nations could have a significant impact on the price of crude oil. This is especially true in case of the top three producers – the US, Russia, and Saudi Arabia. Increase in oil output from any of these nations could cause global supplies to go up, which in turn could pressurize global oil prices. Similarly, decrease in oil output from any of these nations could tighten global supplies, which in turn could lift world oil prices.
In less than two decades, the US production of crude oil has more than doubled thanks to the surging output from the unconventional, shale plays. This technological breakthrough, which involves extracting oil using horizontal drilling and hydraulic fracturing, has led to a structural change in the global oil trade.
Surging output has caused the US toreduce their imports of crude oil, which have been declining steadily since more than a decade. On the other hand, since the removal of the oil export ban in 2015 by the then US President Barack Obama, exports of US oil have surged. The most recent data showed that US exports of crude oil to other nations stood at around 3.4 mbpd, the highest in over two decades.
Rising share of the US in world oil production would make the nation a very important factor affecting the price of crude oil. Any supply-side issues would have a strong impact not only on the price of US oil, but also on the prices of other grades traded around the world. As such, it becomes necessary to keep a close eye on the supply-side developments in the US.
While production is one half of the story, consumption is the other half. And consumption depends on the health of various oil-consuming economies. The US is the world’s largest oil consumer, accounting for a fifth of the world demand. As such, the health of the US has a strong bearing on the demand for crude oil. Slowdown in the US would lead to a slowdown in demand for oil. Moreover, asthe US is the world’s largest economy, it plays a crucial role in the global trade. A US slowdown tends to have a bearing on the health of other economies too, thereby having a double whammy on the global demand for oil. This impact is reversed when the US economy is strengthening.
Another nation that can impact oil price is China, the world’s second largest oil consumer accounting for around 13% of the world demand. We have already seen in earlier chapters the importance of China to the world economy. Not only is China the second largest economy, but it is also a major manufacturing hub. As such, the country always has a huge demand for energy products. Any slowdown in manufacturing activity in China tends to slowdown demand for commodities as well, including crude oil.
Given that the US and China together account for a third of the global oil demand, one must closely monitor the health of these two economies. Some of the key reports that must be monitored are GDP, manufacturing, vehicle production and sales, and consumer sentiment. Sustained slowdown in these indicators suggests that economic activity might be slowing down, which in turn is negative for oil prices. Meanwhile, the opposite is also true when these two economies are experiencing a period of strong growth.
As stated earlier, OPEC production accounts for around 40% of the worldwide production, while OPEC exports account for around 60% of the global oil trade. As such, how the cartel adjusts its supplies in reaction to extreme price swings has a strong bearing on the global oil market balance, and subsequently on oil price. As crude oil is a major source of revenue for all OPEC nations, the member nations of the OPEC cartel closely monitor the price of crude oil.
In an environment when oil price falls too much and too fast, the OPEC tends to reduce their output to squeeze out excess supplies from the world market. Such an action usually causes oil prices to bottom out and start heading higher. Conversely, in an environment when oil price rises too much, the OPEC tends to increase their output to bolster supplies into the world markets and to maintain their market share. Such an action usually causes oil price to top out and start heading lower
Because of the OPEC’s role as a swing producer (increasing and decreasing output as and when needed), their actions tend to have a strong influence on the price trajectory of crude oil. As such, one must closely monitor comments from top OPEC officials as well as the outcome of OPEC meetings, which are held twice a year (usually in June and December) to set the production quotas for each member nations.
Another factor that can influence the price of crude oil is geopolitical developments. This is especially true in case of the middle eastern countries, which occasionally face considerable civil and political unrest. However, geopolitical tensions have no boundaries and can occur outside of middle eastern countries too, such as in Africa or South America. If geopolitical tensions flare up in countries that are important oil producers and exporters, it could cause a significant spike in the price of crude oil depending on the extent to which it hampers production and impacts global supplies. The effect could be even more significant if markets expect such tensions to spread over to surrounding nations that are also important producers and exporters of crude oil. As such, one must keep an eye on geopolitical developments in the middle eastern countries, especially those that form a part of the OPEC group.
Every Wednesday (or on the next working day if Wednesday is a public holiday in the US), the Energy Information Administration (EIA) wing of the US Department of Energy (DOE) releases the weekly crude oil inventory report. This report shows the domestic inventory levels of crude oil and its various refined products on a weekly basis. The refined products include the inventory levels of gasoline and various crude distillates. Also included in this report are other figures such as US weekly oil production, US weekly imports and exports of crude oil, inventories at Cushing (a crucial storage centre for oil that is produced in the US before it is transported to US refineries), refinery utilization rate etc. Not included in this report are the SPR (Strategic Petroleum Reserve) inventory levels, which are crude inventories set aside by the US government meant to be used only during times of an energy.
As already discussed, the US is the world’s largest producer and consumer of crude oil. As such, the inventory report that is released by the EIA is closely scrutinized by traders and market participants to understand the demand and supply trends for crude oil and its refined products in the US each week. Weak demand usually causes inventory levels to rise, and vice versa. Hence, a rising inventory level is usually bearish for price, while a falling inventory level is bullish for price. Given that the report is released each week, the swings in inventory levels can often be quite volatile. As such, to smooth out the data, some traders and market participants prefer using a moving average of inventories to get a better picture of the trend in US inventory levels. To conclude, this report is arguably the most important short-term report that influences the price trends of crude oil, and hence, must be regularly focused on.
We are already aware about price spreads, as we have spoken about them in the various chapters on metals. In the context of crude oil, one can compare the difference between cash and futures or between two futures to understand the demand-supply situation. One can see the trend in spreads between a nearby and a farther WTI contract or between a nearby and a farther Brent contract. If the nearby contract is trading at a lower price than the farther contract, the market is said to be in contango. Similarly, if the nearby contract is trading at a greater price than the farther contract, the market is said to be in backwardation. A contangoindicates a market that is well supplied and is bearish for price, whereas a backwardation indicates a market that is tight in supply and is bullish for price.
The curve structure of WTI and Brent can also tell a lot about region-wise demand-supply situation. For instance, very recently, the WTI futures curve was in contango, while the Brent futures curve was in backwardation. This suggested that supplies in the US were quite ample, while those outside the US were quite tight. Meanwhile, the price difference between WTI and Brent can tell a lot about the state of the global oil markets. Being the global benchmark, Brent is more influenced than WTI is by events taking place outside the US, such as geopolitical tensions among the Middle Eastern and OPEC nations. This coupled with rising US shale oil production has caused Brent to trade at a premium to WTI for the past several years. Keeping a track of crude oil structure and WTI-Brent price differential can help those who do spread trading i.e. buying (or selling) WTI contract and simultaneously selling (or buying) similar-dated Brent contract.
Besides, one can also monitor the price spreads between different grades of crude oil to understand the supply situation within various grades. One such example is monitoring the spread between light,medium, and heavy oil, such as the spread between WTI (light) and WCS (heavy) or that between Brent (light) and Urals (medium). Because heavy oil is complex and more expensive to process, it usually trades at a discount to light oil. Narrowing of this discount can indicate that heavier grades are in short supplies relative to lighter grades or that demand for heavier grades is outweighing that for lighter grades or a combination of both. The opposite is also true when the discount of heavier grades over lighter grades is widening.
Crack spread is the difference between the price of crude oil and that of its derivative products such as gasoline and distillates. It reflects the profit margin for a refiner, who buys crude oil from oil producers to make various refined products that are meant for end consumption. The higher the crack spread, the higher the profit margin for a refiner, and vice versa. One thing that must always be kept in mind is the fact that only refiners buy crude oil. Consumers such as you and I buy end products such as gasoline or diesel and not crude oil. As such, demand for crude oil largely depends on refiners. This in turn depends on their perception of demand for the by-products of oil that they produce. If they perceive demand for by-products of oil to be strong, they will buy higher quantities of crude oil, and vice versa.Crack spread is an important factor that impacts the demand for crude oil. One of the most commonly talked about crack spread is the 3-2-1 crack spread. This spread is calculated as follows:
[(Price of 2 barrels of gasoline +Price of 1 barrel of distillate fuel)– (Price of 3 barrels of crude oil)]/3
The above equation enables one to find out a typical 3-2-1 crack spread per barrel. This spread will be high when output prices (the price of gasoline and distillates) are outperformingthe input price (the price of crude oil), and low when output prices are underperforming the input price. A high, rising spread benefits refiners, who could then bolster their production of refined oil products, which in turn would mean higher demand for crude oil. Similarly, a tight, shrinking spread reduces the profitability of refiners, who could then lower their production of refined oil products, which in turn would mean lower demand for crude oil. As such, regularly monitoring crack spreads can sometimes provide signalsabout the short-term trajectory of crude oil price
One factor that is worth keeping a track of, especially from a long-term perspective, is the availability of substitutes for crude oil. Fossil fuels, such as crude oil, when burnt release a lot of harmful elements into the atmosphere such as carbon dioxide, which is believed to be one of the key factors contributing to global warming. With global environmental norms tightening with each passing day, there is an increasing call for using renewable sources of energy that cause less stress and damage to the environment. If such substitutes of crude oil become available and gain widespread acceptance around the world in the coming years, it could drastically reduce global demand for oil and thereby weigh on oil prices.
One such example is the development that is taking place in the Electric Vehicles (EVs) segment. Unlike Internal Combustion Engine Vehicles (ICEVs) which require crude oil to power their engines, EVs require electricity. One of the biggest factors that has limited the uptake of EVs so far are the high costs of batteries, in turn making an EV relatively expensive to a similar-sized ICEV. However, engine costs of EVs have been declining over the last few years and they are expected to continue declining in the coming years because of the availability of better technologies. If this continued decline in battery costs eventually causes the overall price of an EV to fall to or below that of an ICEV, demand for EVs could start to accelerate. Such a scenario could start undermining demand for ICEVs. As the transportation sector forms nearly 60% of oil’s overall demand, rising demand for EVs in place of ICEVs over the next several years poses a significant risk to global oil demand. Hence, development in this sector is worth keeping a track of to understand the potential impact on long-term demand for oil
Also impacting the price of crude oil is the US dollar. We have seen that metals move in the opposite direction of the dollar. This correlation holds true in case of crude oil too. During periods of sustained dollar strength, there is a tendency for crude oil prices to soften as a strong dollar makes it more expensive for holders of foreign currencies to buy oil. Similarly, during periods of sustained dollar weakness, there is a tendency for oil prices to strengthen. Changes in the larger trend of the dollar can have a strong impact on the price of crude oil.
As such, one must keep a close eye on the broader trends of the dollar. For doing so, one can monitor the movements of the dollar index (DXY), which is the trade-weighted average of the dollar against six global currencies (Euro, British Pound, Japanese Yen, Swiss Franc, Canadian Dollar, and Swedish Krona). A rising DXY means the dollar is strengthening against its major counterparts, while a falling DXY means the dollar is weakening. Generally, rising DXY is bearish for crude oil, while falling DXY is bullish for crude oil.Notice in the chart the two shaded regions. Observe how a major decline in the DXY (blue line) from 2002 to 2008 triggered a major rally in WTI oil (orange line) during the same period. Also observe how a sustained rise in DXY from 2014 to 2015 coincided with a brutal sell-off in oil prices over the same period
When trading crude oil, some of the key things to keep a track of are as mentioned below:
Keep a track of news flows from the top 5 producers of crude oil, given that they account for half of the global output. Increase or decrease in supply from these nations can have a marked impact on the price of oil.
The unprecedented pace of shale oil boom has made the US the world’s largest oil producer. Top oil agencies such as the EIA expect US output to continue surgingin the coming years. As such, one must keep a close watch on the developments that are taking place in the US shale basin.
The US and China account for a third of the global oil consumption. As such, economic developments in these nations must be closely watched to gauge the health of these economies. A slowdown in these economies can significantly lower demand for oil, and vice versa.
OPEC accounts for 40% of world oil production. As such, one must closely monitor the developments in the cartel as well the output levels of each of its member nations.
Crude oil is a commodity that is very sensitive to geopolitical events, given that a significant portion of oil is produced in the Middle East, a region that is subject to frequent geopolitical unrest. Any unexpected rise in tensions in these regions can flare up oil prices.
Given that the US is the world’s largest producer and consumer of crude oil, one must monitor the inventory report released by the EIA every week in order to better understand the short-term demand and supply situation in the US.
One must also monitor crude oil curve structure and price spreads not only of the benchmark grades such as WTI and Brent, but also of those between different grades of oil to better understand the relative demand-supply situation between light to heavy grades.
One must also routinely monitor the crack spreads, in order to gauge short-term demand for crude oil and its refined products such as gasoline and distillates.
Given that the world is going greener, one must keep an eye on oil substitutes as these could reduce demand for oil in future. One such area that is worth keeping a track of is the EV segment, which could severely reduce demand for oil from the transportation sector in the long-term
Lastly, one must also keep a watch on the bigger trends of the dollar, given that the two share a strong negative correlation, especially during important market turning points.
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