The ChoosaBroker Trading Academy
7.5. Non-Agricultural Commodities - Energy Products
The market for energy commodities is complex and dynamic. Their impact on the economy from the local to global is enormous. This makes it important that you follow and understand current trends, as well as likely future changes – not just from a trading and investing point of view, but as a matter of general economic knowledge.
What is Energy Trading?
Energy market is the most vibrant segment of the modern commodities trading market. But this was not always the case. The launch of the first commercial cars in the United States during the early part of the 20th century triggered a huge spike in the global demand for oil. Until then, agricultural staples like corn and wheat were the pre-dominant commodity trading assets.
The significance of energy commodities in general, and crude oil in particular, was further reinforced after technological innovations opened the door for oil to not only fuel cars, but also become a major component in the manufacture of plastics, synthetic textiles, fertilizer, cosmetics, and even steel.
Today, crude oil and its derivative products are the most actively traded commodities in the world. That’s not surprising, considering oil has become indispensible to the smooth functioning of the global economic engine.
What are the Different Energy Trading Assets?
Energy market trading revolves around two main assets – crude oil and natural gas. Let us examine each one of them in detail:
Although the market for oil is global, trading is clustered around two primary instruments – Brent Crude and West Texas Intermediate (WTI). Brent is a light, sweet variety of crude oil that is extracted from the North Sea, and refined in Northwest Europe. It is considered light because of its relatively low density, and sweet because of the low sulphur content. WTI, on the other hand, is refined mostly in the U.S. Midwest and Gulf Coast, and is lighter and sweeter than Brent Crude.
The primary factors that influence crude oil prices are listed below:
- OPEC Policies – The 15-nation Organization of Petroleum Exporting Countries (OPEC) accounts for roughly 40% of the total global oil production. The cartel’s decisions to increase or decrease output are a major determinant of oil price trends.
- Global Oil Inventories – Whenever production exceeds consumption, the excess crude oil gets stored. In the event of a steady build-up of these crude oil inventories, oil prices drop to keep supply and demand in balance.
- Natural Disasters and Geo-political Crises – Wars, natural disasters and political upheavals, especially in the major oil producing regions, can have a disproportionate effect on the price of oil.
- Value of the U.S. Dollar – All the oil that is traded around the world is denominated in U.S. dollars. Depreciation in the value of the greenback typically causes a spurt in demand and prices. Contrarily, if the value of the dollar rises, demand for the commodity can get dampened, hurting prices.
The New York Mercantile Exchange (NYMEX) offers futures contracts for both Brent and WTI Crude. A standard contract represents 1,000 barrels of oil. As a result, a $1 movement in the underlying asset’s price is equal to $1,000. Most futures contracts require around 10% initial margin. But that figure can rise during periods of heightened market volatility.
A cheaper route for the retail investor is the purchase of crude oil-tracking exchange traded funds (ETFs). ETFs trade on stock exchanges and can be transacted in a manner similar to common stocks. For instance, buying one share of the NYSE Arca-listed U.S. Oil Fund (USO) should give you exposure to around one barrel of crude oil.
Natural gas is a fossil fuel composed mostly of methane, hydrogen and carbon. It is the fastest growing primary energy source in the world, supplying more than half of the energy consumed by residents in the United States, and over 40% of the energy consumed by industries there. This wide-spread use of natural gas in the world’s biggest economy, and its steady adoption in key emerging economies, makes the commodity a highly-liquid trading asset.
The major factors on which natural gas prices depend are enumerated below:
- Production – Just like any other commodity, fluctuations in productions levels tend to have a significant impact on price.
- GWeather – Severe weather conditions like hurricanes or storms disrupt drilling activity and can create supply shortfalls.
- Supplies in Storage – The levels of natural gas supplies held in underground storage facilities can influence prices, especially during periods of increased demand.
- Economic Growth – Stronger than expected economic growth generally translates to higher natural gas prices.
Natural gas exchange traded funds (ETFs) and exchange traded notes (ETNs) are another popular investment option. The NYSE Arca-listed Velocity Shares 3x Long Natural Gas ETN (UGAZ), with average daily volumes in excess of 20 million shares, is ideal for short-term traders seeking leveraged exposure in the commodity.
What is Unique About Crude Oil?
Investing in crude oil offers several advantages over other conventional asset classes like stocks and bonds.
- Diversification – Due to low correlation, adding oil commodities to an investment basket comprising solely of equities and fixed income diversifies the risk and lowers the volatility in the portfolio.
- Hedge Against Inflation – In general, commodity values are intrinsically independent of currencies, meaning they retain their values even if the value of a currency were to fall in an inflationary environment.
- Ideal for Speculation – The market for crude oil is characterized by frequent bouts of big price swings, which, in turn, present short-term traders with relatively greater profit-making opportunities.
What is Unique About Natural Gas?
Traders and investors should consider gaining exposure in to natural gas assets for the following reasons:
- Demand for Cleaner Fossil Fuel – Compared to coal and petroleum, natural gas produces lower levels of carbon emission, resulting in both immediate and long-term benefits for the environment.
- Ample Reserves – There are abundant natural gas reserves around the world. If consumption remained at current levels, the International Energy Agency estimates there are enough recoverable resources to last another 230 years.
- Play on Emerging Economies – The rapid industrialisation in China and India has boosted demand for natural gas in those countries. And barring short-term blips, both these economies are expected to continue their growth trajectory, potentially generating even greater demand and higher natural gas prices.
Final Few Notes
Retail investors are increasingly turning to energy commodities because they see the value in investing in an asset class that’s growing in scale and global importance. There is no short-cut to success in this market. Conduct in-depth research; construct a proven strategy; and employ prudent risk management techniques to reap the maximum benefits.