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Energy trading – Common rules and principles of oil & gas trading

Energy trading – Common rules and principles of oil & gas trading

Energy trading is the trading of commodities that belong to the asset class known as “energy assets”. This asset class includes commodities such as:

  • Crude oil (US Oil or West Texas Intermediate crude)
  • Brent Crude oil (UK Oil)
  • Natural gas
  • Heating oil
  • Gasoline

Heating oil and gasoline are derivatives of crude oil, and their fundamentals are therefore inherently tied to the fundamentals of their parent product, crude oil. Natural gas is a commodity asset on its own, which is usually located as a layer of gas on top of crude in the rock formations where drilling takes place.

How are Energy Commodities Traded?

Energy assets are mainly used as raw materials for fuelling purposes. They are traded on various commodity exchanges as futures contracts. A futures contract is a legally binding agreement to buy or sell a specified asset (such as a commodity) at a specified price in the future.

By implication,

1) Futures contracts usually have at least two parties to the trade: a buyer and a seller.

2) Futures contracts have a settlement price and date.

3) They can be settled with physical delivery of the commodity in question, or they can be settled on a cash basis, which is how energy trading on online platforms is done.

Energy trading in which settlement is provided on a cash basis, is usually called spot energy trading. “Spot” here means that the transaction or trade is settled there and then or “on-the-spot”. This allows traders to speculate on whether price of an energy commodity would go up or down without taking physical delivery of the commodity.

Energy assets can also be traded using options trades. Considering that there are various ways to trade options, this will be discussed later as an entire topic on its own. Most of the energy trading you will encounter with the brokers listed on this website is going to be done on a spot basis using long and short orders. These orders are purely based on the differential between the entry price and exit price, as well as the direction that the asset has moved.

What Drives Energy Commodities?

Crude oil is the most popular energy commodity in terms of the volume of energy asset trades. Everyone uses crude oil derivatives in some way: buying fuel for personal cars, transportation of goods and services, powering of engines, etc. In some countries, kerosene (a derivative of crude oil) is still used for cooking. So crude oil commands a lot of trading activity in the financial markets.

Crude oil has two varieties:

1) Brent crude, which is the heavier version. It is the global benchmark for crude oil and features the Oseberg, Ekofisk and Forties blends. Crude sourced from Dubai, Kuwait and Nigeria as well fall under this category and this variety of crude is more expensive than the WTI crude.

2) Light crude, which is the lighter version and is represented as US Oil or West Texas Intermediate (WTI). It is the benchmark used for the NYMEX contract.

What drives crude oil prices?

  • Production quotas from OPEC
  • Natural disasters
  • Speculative activity
  • Political instability (in producing countries)
  • State of Global Economy (especially with countries with high demand such as China)

Crude oil pricing is a factor of demand and supply. All the factors mentioned above all affect either demand or supply. So how do these factors primarily drive demand/supply of crude oil and consequently the day-to-day price of this commodity?

A) OPEC

The Organization of Petroleum Exporting Countries (OPEC) is the cartel of 13 of the major oil producing economies of the world. Saudi Arabia is the number one producer of crude globally and its membership of OPEC is a key factor in the setting of production quotas by OPEC. OPEC countries account for 40% of global production. OPEC meets periodically to decide production quotas for its members, and occasionally cuts output to shore up prices. So news about production quota adjustment is a mover of crude oil prices.

B) Natural Disasters

Natural disasters that affect production hubs (e.g. hurricanes in the Gulf coast of the United States) usually impact crude prices. The bulk of the WTI crude comes from the midland oil pipelines from the Texas area, which is exposed when hurricanes come inland from the Gulf coast.

C) State of Global Economy

A state of global economic recession usually causes the largest consumers of crude oil to draw back on their crude purchases, causing price drops. You can always look at consuming nations such as China for direction in this regard, using their GDP and manufacturing numbers as a guide.

D) Political Instability

As we saw in 2010/2011 when the Libyan civil war caused prices to shoot beyond $120 per barrel, political instability in the producing nations (especially those nations that are OPEC members) causes supply shortfalls which lead to a rise in prices.

E) Speculation

Speculative activity also drives prices of crude oil. Speculators use large amounts of capital to sway prices in either direction, and use certain information that they are privy to in their trading activity.

Natural Gas

What factors influence the prices of natural gas? Just like other commodities, the price of natural gas is subject to demand and supply dynamics. Natural gas prices are affected by:

  • Volume of production
  • Amounts of natural gas in storage
  • Imports/exports
  • Weather patterns
  • State of global economy
  • Pricing/availability of alternative fuels

How do these factors affect prices of natural gas?

A) Production Volumes

The supply of natural gas requires heavy infrastructure. Switching to alternative fuels whenever there is supply shortage is difficult. Therefore, conditions which short-term supply reductions (plant breakdowns, fires, pipeline disruptions or repair-induced shutdowns) can cause large price shifts to the upside. The same can occur when there are short-term demand increases (such as for heating during very cold winters).

B) State of Global Economy

The state of the global economy does have an influence on prices of natural gas. This has more to do with whether countries that use the product in large quantity can afford to buy in the quantities they usually buy when they have lesser money to spend. So when there is an economic boom, natural gas consuming nations can afford to step up their demand for the product. Also, a boom in manufacturing or the industrial sector tends to lead to an increase in natural gas consumption. This is because natural gas is used as fuel for power plants and as feedstock for many industrial processes, especially in the petrochemical sector. So it is expected that a boost in manufacturing will lead to more usage of natural gas, which leads to increased demand and higher prices. For the same reasons working in reverse, a depression in manufacturing/industrial activity will lead to lower demand, which can reduce prices.

C) Weather Patterns

Severe weather can have two effects. There can be supply disruptions when facilities either have to be shut down or when they are destroyed by severe storms or hurricanes. This is very common during the hurricane season in the Gulf of Mexico. Severe cold weather can also increase demand for natural gas as a heating fuel or for power generation. These two weather scenarios can pressurize prices to the upside. Unexpected cold fronts can quickly cause prices to spike due to the short-term nature of this demand pull. However, this can be offset if there is adequate quantity of natural gas in storage.

It is not only during winters that this can happen. Even unusually hot summer weather can increase the need to power cooling systems and air conditioners in homes and offices, beyond the regular levels of demand. If there is not enough storage to offset this demand, this could cause prices to spike. Also, if there is enough natural gas in storage, and this is used to offset the increased summer demand, this could lead to a shortfall in storage volumes during winter, which can cause prices to spike from supply shortfalls. The seasonal variation in demand and supply of natural gas is something that all energy traders focusing on natural gas must be acquainted with to be able to trade the price fluctuations successfully.

D) Storage Volumes

Natural gas is usually stored in underground storage fields. This is done to be able to provide a backup supply that can be deployed quickly to points of usage to offset sudden increases in demand or shortfalls in production, so as to stabilize prices. Excess domestic supply is stored during periods of lower demand. Higher storage levels of natural gas are seen during the months of April through October: this is traditionally a low-demand period. Demand for natural gas for heating during winter increases from November to the onset of spring around March.

Trading Energy Assets

The trading of energy assets involves the use of fundamental analysis, technical analysis as well as sentiment analysis (psychology of market participants). Delving into each type of analysis will take a lot of time. The key points to be considered in fundamental analysis have been mentioned already. But suffice it to say that to trade with technical analysis, you need to have some knowledge of the following:

  • Support and resistance
  • Trendlines
  • Chart patterns
  • Candlesticks
  • Price retracements and extensions

Sentiment analysis requires a knowledge of the psychology of the market participants, as this is ultimately what drives demand for any commodity. In any market, there are buyers, sellers and uncommitted traders. The uncommitted traders tend to swing the price of a commodity either to the north or to the south, when a fundamental influence causes them to switch from being uncommitted to being committed (either to buy or sell). So knowing the psychology of the market using tools such as the sentiment indicators, depth of market tool or market profile indicator, can aid the trader in performing accurate analysis of whether the price of crude oil or natural gas will go up or down.

The best results are obtained when these three forms of analyses are combined together. It also pays to know where the institutional traders are going with their trades as they usually drive the markets with their large trading volumes.

The brokers in our list offer you the opportunity to trade crude oil (US and UK blends) or natural gas using good leverage conditions. Feel free to make a choice from the list.