Although the price of oil impacts our everyday lives, from the price of filling up our car to plane tickets to heating costs to our grocery costs, most people don't know how to trade it. And, if they want to trade it, they don't know whether the price is going to go down, or up.
Factors impacting the oil price
The price of oil is usually determined by supply and demand. Put simply, if the demand for oil is higher than the supply (so there are more buyers than sellers) the price will go up. If the supply is higher, the price will go down.
According to the International Energy Agency, the global demand for oil is expected to reach 91 million barrels a day in 2012. The growth in oil demand is driven by emerging market economies, with OECD demand declining slightly. As far as oil supply goes, in June 2011 daily oil production averaged 88.3 million barrels a day with Saudi Arabia boosting supply from the Organisation of Petroleum Exporting Countries (OPEC).
As a large portion of oil production occurs in the Middle East, political turmoil in this region causes oil prices to rise as investors worry about future supply. Likewise, when non-OPEC supply grows, the risk of supply disruptions lessens as the production burden is spread.
One of the major supply problems concerning oil is oil quality. Many oil refineries require high-quality 'sweet' crude to meet environmental requirements, particularly in the US.
Aside from supply and demand, investor speculation has a large impact on oil prices as they bid on oil derivatives. Many institutional investors, including banks or mutual funds, hold commodity-linked investments in their long-term asset-allocation strategy. Other investors often trade oil derivatives for very short periods to make profits on quick price movements.
How to trade oil
Unlike buying and selling shares, there are a number of ways to go about trading oil.
Above we mentioned oil derivatives. A derivative is a product, usually a type of contract, that derives its value from another asset. In this case, its value is based on the value of oil.
Different derivatives include futures, options and CFDs.
Oil futures are agreements to buy or sell oil at an agreed upon price at a future date. This means that, even if the price in the market has changed, the buyer and seller still need to exchange the product at the end of the contract for the agreed price. Futures involve speculating on what the price of oil will be at a future point in time, generally basing this price on expected future supply and demand.
Options work in a similar fashion to futures. However, unlike futures, the buyer of an option has the right, but not the obligation, to buy the oil at the end of the contract. This means that, if the price in the market is more favourable at the expiry of the option, the buyer can choose not to carry out the option and can simply buy the oil on the market instead.
Although options and futures are both based on the exchange of an asset at a future point in time, most of these contracts don't result in the asset changing hands. So, in the case of an oil future or option, the oil doesn't actually move from the seller to the buyer. Instead, traders and investors usually try to profit on these contracts by buying and selling them at a better price than they originally paid.
A CFD, or contract for difference, is an agreement to exchange the difference in price of an asset between the time at which the contract is opened and the time at which it is closed. So if you bought an oil CFD at one price and the price of oil went up, you could then sell it at a higher price, profiting on the difference. If the price went down you would make a loss.
CFDs allow you to trade on the changing price of oil without investing in oil itself. As you aren't investing in the actual commodity, this means that you can access a wide position for a relatively small deposit, or margin. As your investment is smaller than it would have been if you were actually trading in oil, you can use your extra capital to either open more trades on different products, or a larger trade on more oil.
For traders uncomfortable with derivatives, they can cash in on the changes in oil prices by investing in the stocks of oil drilling and service companies. They can also invest in exchange-traded funds (ETFs). A fund is when an investment manager pools the capital of a number of investors, and then uses the grouped sum to invest in a range of assets. Investing in an ETF can be a good way to get some instant diversification into your portfolio, which can lower your risk and result in more consistent profits over time.
That being said, as derivatives are based on the values of other assets, they are also available on shares and, in some cases ETFs. CFDs, for example, are available not only on commodities, but also on shares, stock indices, forex, binaries and options.
Conclusion
Trading oil gives the potential investor a wide range of opportunities to make a profit. From direct exposure to commodities through derivatives, or indirect exposure through the stock of an energy company, there is usually an option for every trader.
CFDs are leveraged products, meaning you can lose more than your original deposit. CFD trading might not suit everybody, so please ensure you understand the risks involved.