The Oil Market
This article gives a broad overview of the forces driving the oil market and how to include oil in your investment portfolio.
Big movements in the oil price have significant ramifications around the world. But just what makes the price move and how do the oil markets work?
Crude oil, also known as petroleum, is the world’s most actively traded commodity.
The largest markets are in London, New York and Singapore but crude oil and refined products – such as gasoline (petrol) and heating oil – are bought and sold all over the world.
Crude oil comes in many varieties and qualities, depending on its specific gravity and sulfur content which depend on where it has been pumped from. If no other information is given, an oil price appearing in UK and other European media reports will probably refer to the price of a barrel of Brent blend crude oil from the North Sea sold at London’s International Petroleum Exchange (IPE).
This would commonly be in a futures contract for delivery in the following month.
In this type of transaction, the buyer agrees to take delivery and the seller agrees to provide a fixed amount of oil at a pre-arranged price at a specified location.
Futures contracts are only traded on regulated exchanges and are settled (paid) daily, based on their current value in the marketplace.
The minimum purchase is 1,000 barrels.
Because there are so many different varieties and grades of crude oil, buyers and sellers have found it easier to refer to a limited number of reference, or benchmark, crude oils. Other varieties are then priced at a discount or premium, according to their quality.
Brent is generally accepted to be the world benchmark, although sales volumes of Brent itself are far below those of, for example, some Saudi Arabian crude oils.
According to the IPE, Brent is used to price two thirds of the world’s internationally traded crude oil supplies.
In the Gulf, Dubai crude is used as a benchmark to price sales of other regional crudes into Asia.
This is not because there are more supplies of Dubai crude oil than of any other grade – there are not – but because it is one of the few Gulf crudes available in single, on the spot, sales as opposed to long term supply contracts.
However, if supplies became extremely limited and price swings became exaggerated, a new benchmark would have to be found.
In the United States, the benchmark is West Texas Intermediate (WTI).
This means that crude oil sales into the US are usually priced in relation to WTI.
However, crude prices on the New York Mercantile Exchange generally refer to ‘light, sweet crude’.
This may be any of a number of US domestic or foreign crudes but all will have a specific gravity and sulphur content within a certain range.
‘Sweet’ crude is defined as having a sulphur content of less than 0.5%.
Oil containing more than 0.5% sulphur by weight is said to be ‘sour’.
Slightly confusingly, the Organisation of Petroleum Exporting Countries (OPEC) – a cartel of some of the world’s leading producers – has its own reference.
Known as the OPEC basket price, this is an average of 15 different crudes.
The oils included are Saharan Blend from Algeria, Girassol from Angola, Oriente from Ecuador, Minas from Indonesia, Iran Heavy, Basra Light from Iraq, Kuwait Export, Es Sider from Libya, Bonny Light from Nigeria, Qatar Marine, Saudi Arabia’s Arab Light, Murban from the Emirates and BCF 17 from Venezuela.
OPEC aims to control the amount of oil it pumps into the marketplace to keep the basket price within a predetermined range.
In practice, the price differences between Brent, WTI and the Opec basket are not large.
Crude prices also correlate closely with each other.
We believe that oil will eventually bounce from these current low levels but taking a direct position is probably too hazardous with the current volatility.
A risk-controlled trade which could be put into practice would be to buy Crude oil CALL options.
For example, you could purchase a May 2021 50 USD CALL option for the price of 2.50 USD.
This means you have full exposure to the oil price from the level of $50 USD per barrel up to the 15th of May 2021. As each option is for 1000 barrels the total investment is $2,500 USD (1000 x 2.50 per barrel)
If oil was to reach $60 in May you would receive a gross profit of 10,000 USD for a total risk of 2,500 USD.
New to investing? Read about How to keep your investment decisions simple.
For more insights on Australian share market, read Advisors Daily Market Summary from our expert team to keep you up to date on the changing Australian and international markets.
This article does not take into account the investment objectives, financial situation or needs of a particular person or entity. Before acting on any investment strategy or advice you should first consult with your current ASIC accredited investment professional or seek out a compliant investment professional for such.