How to trade Oil
Good day, comrades forex traders!
80 years ago, Professor of Economics at New York University Myron Watkins wrote: "The problem with oil is that there is always too much or too little of it." And over the past couple of years, this has been especially felt: the markets are suffering from an oversupply, which forces OPEC countries and partners to agree among themselves and limit production. The goal is to stabilize prices and gain time needed to carry out the fundamental structural reforms that this most important industry of world production needs today.
How the oil markets have developed to this day, about the current state of affairs and the near future, the volatility of the relevant instruments, as well as the strategies that can be used to make profit on the Black Gold movements, are detailed in our material. After all, not only the oligarchs get rich, traders also want their own "house for the duck" 🙂
Cost of production in different countries
Oil in 2017 once again confirmed its reputation as one of the global factors affecting the global economy. Nevertheless, the extraction of black gold in the world varies greatly, both in technology and in cost.
As we can see from the table below, the cost of shale oil production in the United States fell to $ 20 per barrel, thus approaching the cost of production in the usual way. This state of things is explained by the fact that shale oil production technologies are rapidly improving, and if in 2012 the cost of production in this way was about $ 100, then in literally 4 years it was able to be reduced by almost 5 times.
The cheapest oil production remains in Saudi Arabia and Iran: 4 and 5 dollars, respectively.
As for Russia, already in explored old fields, the cost of oil production does not exceed $ 6, while in new fields it is about $ 16.
Brands Brent and WTI
Marker or reference grades of oil are grades of oil with a specific composition (sulfur content, density), the prices of which are widely used when setting prices when buying and selling various types of crude oil for the convenience of producers and consumers of oil.
There are three main marker varieties in the world: Brent Blend, West Texas Intermediate (WTI) and Dubai Crude. Quotations for these varieties published by quotation agencies determine prices in the main regions:
- Brent, mined in the North Sea - for European and Asian markets. Prices for approximately 70% of exported oil are directly or indirectly set on the basis of Brent quotes;
- "WTI" (West Texas Intermediate), also known as "Texas Light Sweet" - for the Western Hemisphere (USA) and as a guide for other grades of oil. In the XX century, for a long time was the only marker variety;
- The Dubai Crude marker grade is widely used in determining the prices of oil exported from the Gulf countries to the Asia-Pacific region.
Typically, marker varieties are associated with some major field or group of fields, oil from which has similar properties and is openly traded on the market with sufficient liquidity.
The US standard is WTI (also Light Sweet), a light oil produced in Texas. Currently, the West Texas Intermediate marker grade is used mainly in the United States (traded with delivery to Cushing, Oklahoma), to set the price of oil produced in the United States, as well as for some imported varieties. WTI is light (API density) and sweet (low in sulfur) oil, which makes it suitable for processing into low sulfur fuels (gasoline and diesel). WTI oil production accounts for about 1% of global oil production.
European Brent oil has a slightly higher density and higher sulfur content, but is also high-quality oil. So Brent - originally meant oil produced in the UK on the offshore field of the same name (discovered in the 1970s), but later oil was added to it extracted at three neighboring fields in Britain and Norway. Currently, the mixture includes oil produced from 15 different fields. This brand has become a reference due to the reliability of supplies, the presence of several independent suppliers and the willingness to purchase it from many consumers and processors. Despite some supply problems in the past and not the largest production volumes, the Brent blend has sufficient liquidity to remain a marker. The oil production of the Brent blend is about 1% of global oil production.
At the same time, WTI has lower price levels, while Brent serves as the best indicator of world prices in recent years.
The price difference (spread) of these two grades was quite narrow until the end of 2010, when the two markets diverged sharply due to the changed situation of supply and demand related to the growth of production in the USA caused by the technology of the shale and oil sectors, while Brent drilling has undergone a forced reduction. In recent years, the spread between WTI and Brent has narrowed, but the current supply factors are still able to reproduce a new dissonance.
The changes in the infrastructure for oil storage and transportation through pipelines in the United States are so significant that they are very likely to lead to major changes in the market in the coming years. These changes could spur growth in domestic US oil product volumes and increase WTI's role as a global benchmark.
The catalyst for this transformation was a sharp increase in US oil production, as well as the lifting of the ban on the export of American oil at the end of 2015. To turn from a net oil importer into an exporter, the United States will have to launch several key pipelines in reverse. At the same time, refiners and oil storage operators on the Gulf of Mexico are starting to build up existing capacities.
A number of new terminals are under construction along the Gulf of Mexico to serve a growing number of vessels arriving to load oil destined for the international market. These infrastructural changes will lead to the transformation of the United States more into an oil supplier to the world market, able to respond quickly to changes in demand and supply, rather than into a regional exporter. All this will allow manufacturers to take advantage of the arbitrage opportunities that exist on the other side of the Atlantic.
Oil at brokers
Today, oil prices are being watched even by people who have absolutely nothing to do with stock trading. This is due to the fact that the dollar is pegged to oil.
In general, oil trading volumes have a common volume standard: 1000 barrels per contract. But outside the limits of Forex, you can manipulate any volumes, up to the calculation of tons and wagons.
At the same time, the largest volume of transactions with oil is noted at two leading sites: the New York and London (InterContinental Exchange) exchanges. Oil is also widely traded in Dubai, Tokyo and Shanghai, however, the volumes here are several times less than in the USA and Great Britain.
Forex oil trading is almost the same as currency trading. The only difference between them is that oil and currency have different leverage and margin levels. One oil trade contract may be equal to 10, 100, 1000 or more barrels of oil. All must be priced in US dollars. Forex oil trading is CFDs, OTC financial instruments that have a specific expiration date and a cash settlement.
A Contract For Difference (CFD) is a financial instrument that allows you to trade in assets such as gold and oil, gas and nickel, cocoa and cotton, without these goods available. In transactions that are aimed at making profit from changes in the prices of certain goods, the goods themselves are not interested in traders. Of interest is only the difference in price. CFDs allow you to get this exchange rate difference without a real purchase / sale.
The time for oil trading at Forex starts on Monday at 01:00 (GMT) and ends at 22:00 on Friday. This applies to both oil trading from the United States and from the UK. We also see that there is a small time interval - the so-called “break” - it lasts from 23:00 (GMT) until 01:00. Each contract has its expiration time. When it arrives, all contracts that have not been closed will be automatically closed, and all open orders canceled. If you decide to resume trading, then you will have the opportunity to open additional positions that are calculated at the new rate and will already have a different expiration date.
Designation of oil brands at brokers
WTI oil CFDs are found under various designations, the most common of which are WTI and CL. As for the Brent brand, various options are possible here, but most often in dealing centers it has two subspecies - BRN (based on ICE futures) and BZ (quotes for settlement contracts from the New York Stock Exchange).
In addition, some companies use their own tickers, for example, USOIL and UKOIK codes are widespread, i.e. "American oil" and "British oil", but their quotes are fully consistent with the flow of data on the previously mentioned futures. In the specifications of various brokers you can also find such designations of oil: QM, WBS, XBZ. Therefore, it is important to clarify such nuances with your broker.
As for CFDs for gasoline and fuel oil, everything is much simpler in this case, since the futures contracts laid in their foundation are traded only on NYMEX (New York Mercantile Exchange - New York Mercantile Exchange), therefore they depend mainly on trends in the US economy. In DC terminals, similar tools are found under the tickers HO (fuel oil) and RB (gasoline).
Long term trend
WTI crude oil rose after World War I, peaking in the 1920s, and followed a sideways trend until the 1970s embargo led to a parabolic rally of up to $ 120. It reached its peak in the late 70s, followed by a winding decline, until the 2000s, or rather, until the end of 1999, where it is worth noting the most powerful decline in global business activity. Ultimately, oil reached its highest historical level of $ 144 in July 2008. And by 2010 it had fallen to the widest trading range between $ 70 and $ 130, which it held until mid-2014, followed by a decline to multi-year lows. At the moment (summer 2017), oil of this brand is being traded in the region of $ 45.
Now, on the agenda today is the problem of overproduction, which, combined with weak global demand, as well as increased shale oil production in the United States, has led to lower oil prices. And after the sanctions against Iran were lifted, in 2016 the cost of Brent dropped to $ 27.72, updating the 13-year low. And today, exporting countries regulate this problem by mutually reducing production quotas, which can only alleviate symptoms, but do not lead to a solution to the urgent problem of overproduction.
And, perhaps, now only a consistent recovery of the global economy, industrial activity and consumer demand can serve as a necessary climate for rising oil prices.
What affects oil quotes?
As mentioned earlier, a huge number of factors can affect the change in the cost of oil. Let's take a closer look at each of them.
Natural. In order to effectively and efficiently trade for as long as possible and take the right position in the market, you need to determine the level of oil deposits in a particular region and the possibility of their depletion in the near future. At the same time, the climate situation must be taken into account, for example, global warming can reduce the amount of oil purchased. These are statistics that provide information on oil reserves and their possible depletion in the future. It is believed that global warming could lead to a decrease in oil reserves.
Geopolitical. The presence of agreements between certain countries, as well as associations of oil producers, can have a huge impact on the change in the cost of raw materials. The establishment of agreements or the emergence of conflicts between producing countries and oil consumers may affect the value of a commodity asset in the short term. The price of oil clearly responds to exacerbation of geopolitical tensions, as large reserves of raw materials are concentrated in regions in which local armed conflicts do not subside. There are plenty of examples, but the most recent of them is the conflict in Libya. Currently, a turbulent situation is developing in Iraq and Sudan, and indirect signs also indicate possible disruptions in Nigerian supplies.
The amount of crude oil reserves. Information on the amount of oil reserves in a given country periodically falls into the press and is capable of fundamentally changing the current rate. In the graph below you can see the change in the amount of oil reserves in the United States.
Such information should be used very carefully, since the fact of a decrease in stocks over the week does not guarantee that the demand for raw materials will increase, but recent years have shown that overstocking of storage facilities is always accompanied by a decrease in quotes of "black gold", i.e. in the modern market, it is the buyer who dictates his conditions, not the seller.
News background. It is necessary to carefully monitor the fundamental background: meetings of exporting countries, statements by individual officials attached to the energy industry, individual industrialists, as well as weekly reports on US reserves, the final reports of which can be found here, and on the number of drilling rigs in operation. The reports of OPEC and the US Department of Energy have a significant impact on oil and the US dollar. In addition, you should be very careful about various reports, for example, on the number of drilling rigs in the USA:
In addition, it is worth tracking supply and demand in the markets, as well as monitoring trading volumes and stocks in the United States.
Processing and distribution problems. Both that and another costs money and the more this price, the less profitable the producer to extract oil and the more expensive, and therefore less competitive, the final product becomes.
The growth rate of world economies. The faster the economy of the United States, China and the whole world grows, the higher the demand for energy.
New technologies. The most striking example is the production of shale oil in the United States, which increases supply and puts pressure on prices. Contrary to rumors about the high cost of this oil, in many fields it is $ 40 and even $ 30.
The last group of factors includes various emergency situations.. This includes fires on platforms and factories, storms in the Gulf of Mexico and the North Sea, conflicts in the Middle East, the imposition of sanctions on export / import of oil, and others.
The main reasons for the fall in oil prices at the end of 2014 are not economic, but rather geopolitical prerequisites. Saudi leaders, a country that owns a quarter of the world's oil reserves, have decided that the price of a barrel of $ 120 is too much. Indeed, in the late 90s oil was only worth $ 12, but after a few years, oil prices unexpectedly jumped up to the displeasure of Saudi leaders, who believed that a barrel of oil should be significantly lower. To bring down the price, they began to sell oil at a price below market, which led to a decline in its exchange rate.This played into the hands of the United States, since this country is one of the largest oil consumers in the world. Despite the active development of oil fields, the United States is experiencing a huge shortage of oil for the country's needs, therefore it is forced to buy "black gold" in other countries. The decline in oil prices contributes to the acquisition of US oil at the lowest prices, which cannot be said about Russia, whose economy is directly dependent on oil prices.
By the way, the powerful upward trend in the oil market, which was observed from 2000 to 2008, was due to the real physical demand for energy from China. Economists even came up with a special name for this period - the "super-cycle."
Below you can see a graph of the correlation between the cost of Brent crude oil, the Dow Jones Industrial Average DOW 300 and the DAX stock index:
The chart is very interesting - it shows the correlation of oil prices and the state of the world economy. Moreover, it is clearly seen that since the end of 2014, the correlation has been severely disrupted. This means that at the moment, for oil prices, the main driver is not the economy, but rather geopolitics. However, until 2014, changes in the global economy were almost always reflected in black gold prices.
The relationship between the US dollar and oil
When trading oil, the American dollar is used; all transactions are concluded in this currency. It is much more convenient and simpler. If various currencies were used to trade oil, traders and other participants in the exchange would have to perform many unnecessary actions. Today, oil can be regarded as an independent currency. And, as everyone knows, any modern national currency is equivalent to American dollars. Thus, the euro refers to the dollar, various national currencies refer to the American dollar, and it in turn is correlated with "black gold". The price of oil sets the change in the exchange rate of the dollar, the national currency and the euro. Below is a EURUSD chart on which I overlaid a WTI crude oil chart:
Quite often, price movements on oil prices precede movements on major currency pairs.
Over the past 50 trading days, oil on average showed absolute daily changes of + - 1-2%. This is significantly lower than last year. Referring to the moving average from 1983, we can say that from the end of 2014 to the beginning of 2016, when prices approached the lowest lows, daily volatility spikes averaged around + - 4%.
Thus, today the volatility in the oil markets remains moderate, but can significantly change at any time - as the geopolitical processes in the Middle East and South Korea develop, the dynamics of Chinese productivity, Euro-skeptic sentiment, as well as the US Federal Reserve’s policy sucking capital uncontrollably from emerging markets. Once again, in historical terms, the average daily volatility of oil prices remains quite high.
Key Trading Strategies
If you are just starting to get used to forex trading, I do not recommend starting trading in oil. Quotations of "black gold" are too dependent on many events, despite the fact that these events are not always associated with the economy. In order to successfully trade in oil and make a profit, you must understand the market sentiment and understand the geopolitical situation in the world.
Oil trading is a unique and highly specialized field that requires exceptional skills in order to build a system for generating stable profits from this type of activity. That is why there are so few small speculators in this market.
The main indicators that are recommended for use in oil trading: Bollinger Bands, MACD, RSI, Stochastic and others that are familiar to traders.
An excellent addition to the indicators you will use the good old Price Action. Analysis of candlestick patterns, direction and strength of the trend, determination of support and resistance levels, trend lines and graphic patterns will significantly improve your trading. Moreover, oil charts are characterized by protracted long-term trends with a small number of pullbacks, as well as a fairly small number of false drifts.
The VSA method has also long established itself as an excellent approach for trading with futures and commodities. As we have already said, one of the most effective trading solutions for working with oil is futures trading. Here VSA opens up new opportunities for the trader in oil transactions. VSA also provides great opportunities for tracking leading market trends and for further forecasting. Thus, you can see the real volumes of closed transactions with their reference to price indicators.
Like all other products, energy is subject to seasonal factors. Recall that seasonality is understood as a complex of phenomena and events that lead to a predictable increase or decrease in the prices of the underlying asset over the studied time interval. Many traders use this seasonality factor in their strategies or even build their strategies based on it. The chart below shows the 15 year seasonality of the Brent brand (red), 12 year old (green), 10 year old (blue), 9 year old (orange), and 7 year old (ocher).
Since oil is used to generate energy, demand for it increases significantly in the winter, that is, when severe frosts occur in North America. It should be noted that in recent years this pattern has been making itself felt more often, meteorologists have even coined a special term - the polar vortex, which was called a climatic phenomenon that brings severe frosts to the Great Lakes region. As a rule, a similar impulse is observed in January and February and lasts at least until March. A similar picture is observed in fuel oil, since it is this fuel that is used for heating private houses, industrial buildings, and is also used to generate electricity (in winter the night is much longer than in summer - this factor also affects prices).
Then there is a decline until the summer months, when many people go on vacation and gasoline traditionally rises in price. Along with it, oil is getting more expensive until September. In September, oil usually begins to fall in order to repeat its traditional rise in the new year and repeat this cycle again. In this case, the trend is due to several reasons. Firstly, the demand for fuel is falling, as the peak of the automobile season has been passed, and the most complex agricultural work has been completed. Secondly, despite the fact that during the hot months the demand for electricity for air conditioning increases, generating companies prefer to use gas rather than fuel oil, since in the USA it is relatively cheap and avoids problems with environmental monitoring. And thirdly, the volume of oil and oil products supply is at a stable high level, since it is easier to extract and transport raw materials in the summer, especially in the northern hemisphere (USA, Canada, North Sea, etc.). On the other hand, demand is less elastic, since it depends on the dynamics of the entire global economy, therefore companies and factories often work “for storage”, i.e. pump energy into storage facilities.
For 15-year-olds, 12-year-olds, 10-year-olds, this can be seen quite well, for 9-year-olds and 7-year-olds, it is worse - the greater influence of recent years affects. Notice how well the data matched before 2010-2012. After the first ten years of the 21st century, which was perfectly suitable for seasonal strategies, the oil situation became aggravated, destabilized, new factors began to influence prices and seasonal trade is no longer as powerful a tool as it was before. Nevertheless, certain seasonal trends to one degree or another remained, which can be easily seen on the presented chart. Such trends allow us to identify the preferred direction for transactions, in other words, if a long-term pattern contradicts the technical picture, it is reasonable to abandon speculative operations, but in the opposite case, i.e. if the technique coincides with seasonality, the probability of working out the signal increases significantly.
As noted earlier, due to the impact on the mood of bidders, specific factors, prices of different grades of oil or refined products can diverge significantly.
A similar difference between the prices of related assets is called the "inter-commodity spread." It should be noted that this term has nothing to do with the usual difference between ASK and BID quotes, information about which can be found in the specification of instruments. Unfortunately, the capabilities of the MetaTrader4 terminal are very limited and do not contain many of the functions available on popular exchange platforms, so the spread between oil CFDs has to be built using auxiliary indicators:
In the chart above you can see prices for the two most popular brands - WTI and Brent. As can be seen from the graph, the quoted prices of the instruments diverge, then converge back. This value (the distance between prices) is usually called the spread and its chart can also be built:
Spreads are traded in the same way as with the help of oscillators - they put trend indicators on them, draw levels and trend lines, look for graphic patterns and so on. At the same time, an increase in the chart indicates that the spread between the brands is diverging and, if there is a sufficient discrepancy (ideally in the red zone), it is worth entering the deal (in my case, buying Brent and selling WTI), and closing the deal if the spread is in the blue zone.
In addition, when analyzing the spread between two brands of oil (it turns out like a synthetic tool Brent / WTI), one can also be guided by seasonality. Moreover, seasonality in this case is more pronounced:
In the figure above, the real spread is indicated by a thick black line. Thin color - spread, averaged over a different number of years (from 15 to 3). Even with the naked eye it can be seen that a fairly considerable number of trends are repeated from year to year, which can also be profitable.
Here I would like to dwell in more detail on specific timeframes, since the spread behaves differently on different time ranges. The chart above shows the markup on D1 - this is a classic of spread trading, since only at large intervals is the obvious range of fluctuations visible.
This is due to the fact that the discrepancy between CFDs on oil depends mainly on the situation in the Middle East and Africa, in particular, when geopolitical uncertainty is growing, demand for Brent is noticeably increasing, since energy supplies to Europe can be violated, while in North America the market is functioning normally it turns out that the need for WTI remains the same.
If we once again focus on the chart, we can see that the spread increased significantly just after the operation in Libya, when oil supply in the Mediterranean was significantly reduced. Further outbursts were recorded during the exacerbation of the conflicts of Syria and Northern Iraq. Thus, if new hotbeds of tension form in Africa or the Middle East, it is advisable to buy CFDs for Brent crude oil and simultaneously sell the same amount of WTI - this tactic helps protect against random speculative fluctuations that are vulnerable to single contracts, because sometimes the “foundation” is stronger geopolitics.
If we consider smaller timeframes, then in this case, transactions with the spread become more risky, since the ranges are often violated, and stable trends are formed on the synthetic indicator itself. Nevertheless, even in such conditions, you can earn money if you make decisions after analyzing important regional news. Here is a typical short-term spread trade:
On May 25, 2017, the spread was in the upper zone, which indicated the possibility of a deal. After the GDP per pound at 11:30 came out worse than forecasts and the market stopped storming, you could safely enter into a deal with the expectation of narrowing the spread from 2.82 cents. As we see, the spread chart calmly continued to decline, the news background was calm, but on June 7, 2017 at 17:30 the news on US oil reserves was due, which would most likely serve as fuel for the new movement. And since we are already in profit and do not have insider information about the upcoming news, we exit the transaction when the spread has reached $ 1.92. As a result, we lost $ 0.2 on two spreads, but earned $ 0.7 or 70 points in this transaction.
And since it came to energy-based spread trading, one cannot fail to mention the discrepancy between WTI and fuel oil, since the latter is a fairly popular raw material in the United States for heating and energy production, as a result of which its prices are more sensitive to seasonal consumer demands.
Oil as an investment asset is interesting, primarily because of the high volatility. Due to a possible significant change in the oil rate in a short period of time, high profits are possible.
Oil CFDs could be seen to provide ample opportunity for speculative and investment decisions. At the same time, oil is the only raw material asset that is available in the range of almost all DCs.
As for the advantages of oil contracts in comparison with currency pairs or other assets, it should be noted that they are more predictable from the point of view of fundamental analysis, especially when it comes to cross-product spreads.
Nevertheless, in order to successfully trade in oil, considerable knowledge and experience are needed, in addition, you must be aware of a very wide range of news and events from different areas.