Oil Trading Strategies: The Importance of Fundamental Analysis
Crude oil is a highly traded commodity. As far as commodities go, the oil market is as liquid as it gets. With so many people around the world trading oil, why not get in on the act?
In this article, we will explain what crude oil is, the different types of oil and ways you can trade it, the importance of using fundamental analysis in your oil trading strategies and more!
What is Crude Oil?
Crude oil, a naturally occurring fossil fuel, is the primary energy source in the world. It can be refined to produce numerous petroleum products which in turn can be used as fuel for transport, heating, electricity and so forth.
When people talk about crude oil they generally speak of two different types, Brent and West Texas Intermediate (WTI).
Brent and WTI Crude Oil
Although there are many types of crude oil, these are the two most popularly traded and act as benchmarks for the oil industry as a whole. Brent crude is extracted from the North Sea and acts as a benchmark for most of the oil produced in Europe, Africa and parts of the Middle East.
On the other hand, WTI crude accounts for oil produced in West Texas and other US states and acts as a benchmark for North American oil production.
How to Trade Oil
Other than buying the physical commodity itself, there are a variety of different ways to attempt to profit from changing prices in oil:
- Stocks
- Contracts For Difference (CFDs)
- Exchange-Traded Funds (ETFs)
- Futures
- Options
- Spread Betting
At Admirals, you can invest in oil stocks and ETFs as well as trade oil using CFDs! CFDs are a financial derivative which allow traders to profit from both rising and falling markets as well as trade using leverage.
You can start trading oil strategies with CFDs on Brent and WTI crude oil by clicking the banner below and opening an account today!
How to Construct Oil Trading Strategies
When people create trading strategies, they are usually based on one, or both, of the following types of analysis.
- Technical Analysis
- Fundamental Analysis
With many financial assets, traders can use either type of analysis independently of each other. For example, many people who scalp the Forex market will rely solely on technical analysis of their chosen currency pair’s price chart.
However, this ‘technical only’ approach is not recommendable for other financial assets, such as crude oil. Given crude oil’s high sensitivity to geopolitical events, successful oil trading strategies must include some form of fundamental analysis.
Therefore, before taking a position in the oil market, it is important to evaluate the fundamentals. In order to show why this is the case, let’s look at what affects the price of oil.
What Affects Oil Price?
As with any commodity, oil price is driven by global supply and demand. However, unlike many other commodities, these factors can be affected by a variety of global events, causing oil prices to be quite volatile.
Below we will explore some of the drivers behind oil price.
Economic Performance
The overall health of the economy tends to dictate demand levels for oil, with demand rising in times of economic boom and falling amid recession or uncertainty. Therefore, we can say that there is a positive correlation between the price of oil and economic growth.
As coronavirus spread across the globe at the beginning of 2020, demand for oil dropped due to the economic impact of the pandemic. The market was over-supplied with crude, with oil companies reputedly running out of space to store it. This caused oil prices to plummet.
The graph below shows the rapid decline of WTI crude during this time period. WTI future contracts which had a May 2020 expiration date, were trading below zero for the first time ever, meaning people were paying others to take the contracts off their hands.
Global Conflict
Global conflict, or even the fear of global conflict, particularly between two oil producing countries can cause concern over future supply and therefore a spike in oil price.
On 3 January 2020, oil prices jumped following news that Iranian General Qasem Soleimani was killed by a US drone strike, which prompted fears of a consequent conflict.
Supply Outages
Significant supply reductions caused by equipment breaking down or being destroyed will cause a rise in global oil price.
On Saturday 14 September 2019, a drone strike destroyed a major Saudi Arabian oil refinery forcing it to close half its total oil production. This reduced the global output of oil by 5.7 million barrels, or 5%, a day.
After closing at $60.43 on Friday, Brent crude opened trading at $69.97 on Monday morning.
The Organisation of the Petroleum Exporting Countries (OPEC)
OPEC and its allies sometimes make production cuts or increases to change the global supply and, therefore, price of oil. For example in April 2020, members agreed to cut production by 9.7 million barrels a day in May and June and later extended this through July as well.
As shown in the chart below, this supply reduction helped oil prices recover from their lowest level since 2002.
International Relations
If international relations deteriorate to an extent where sanctions are imposed on an oil producing country, this will have a negative impact on the demand for that country’s oil. This in turn will increase demand for oil elsewhere, increasing prices and most likely causing the sanctioned countries oil output to fall.
On 22 April 2019, the US announced that unless buyers of Iranian crude ceased purchases by 2 May 2019, they would face sanctions. This news caused oil prices to rise, among fears that these sanctions, together with similar sanctions on Venezuelan oil, would cause the particular type of heavy crude that these nations produce to become scarce.
The US Dollar
Crude oil, like many other commodities, is priced in US dollars and, therefore, there is a direct, unambiguous relationship between the two.
When the US dollar is particularly strong, oil prices are relatively higher for non-dollar buyers of oil. This leads to drops in international demand and, subsequently, drops in price. The opposite is also true.
The growing strength of the US dollar played a significant part in the oil price collapse of 2014.
Following the ‘Great Recession’ of 2008, the Federal Reserve imposed measures which included zero percent interest rates and quantitative easing.
This change in monetary policy caused the value of the dollar to fall. This in turn contributed to recovering oil prices following a steep decline caused by the recession.
In 2013, the Federal Reserve began a course of strengthening the Dollar. By 2014 prices of commodities such as crude oil, began to fall. However, it is important to add that the stronger dollar only contributed to the rapid decline in price.
Other factors included saturation of the market. This was caused by reduced demand from countries such as China, whose rampant consumption of oil during their economic boom at the beginning of the millennium had begun to slow down after the turn of the decade.
Where to Check the Fundamentals
Reading the news, keeping an eye out for international relations where one, or both, of the countries is an oil producer and also paying attention to the strength of the dollar are all important.
There are also a number of reports which can provide you with extra insight, before taking a position in the market. Below we have listed some reports you can look out for:
- OPEC
- OPEC releases monthly and annual reports. Monthly reports cover issues facing the global oil market and also provide a market outlook for the coming year. Whereas annual reports focus on reviewing OPEC member countries performances as well as looking at the current state of the market.
- OPEC members also hold meetings twice a year. You should look out for when these meetings take place, as they may make big decisions regarding their combined output.
- Energy Information Administration
- The EIA produces the ‘Weekly Petroleum Status Report’. Within this report there is information regarding the current supply, stock and prices of crude oil in the US. Most interesting is the weekly change in stocks of crude oil. If crude oil stocks are increasing, this implies either demand is falling or there is an increase in production.
Of course these are just a few ideas to get you started, there are many others out there which give insight into the current state and possible outlook of the oil market.
Final Thoughts
You should now have an idea of the global events that can influence the price of crude oil and, therefore, how important it is to incorporate fundamental analysis into any oil trading strategies.
Make sure you are aware of any global issues which may affect oil prices in the future, as well as having an idea about the current state of the industry in general. Only then should you think about entering the oil markets.
If you are new to trading, you should test any oil trading strategies with a demo account prior to putting your own capital at risk. Luckily for you, at Admirals, you can do just that.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
