Crude Oil Simplified

Crude oil is a liquid fuel source located underground.

It is extracted through drilling. It is the base for lots of products. These include transportation fuels such as gasoline, diesel, and jet fuel. They also include fuel oils used for heating and electricity generation.

One barrel contains approximately 158.987 litres. So the prices that normally heard are per barrel.

Crude oil can be categorised into different categories based on its gravity and sulfur content.

Mostly medium and sweet, medium and medium sour is used most affordable and easily usable.

Crude oil is categorised among 3 categories based upon the countries of extraction:

Brent is the reference for about two-thirds of the oil traded around the world, with WTI the dominant benchmark in the U.S. and Dubai/Oman influential in the Asian market.

1)Brent Crude

“Brent” actually refers to oil from four different fields in the North Sea: Brent, Forties, Oseberg, and Ekofisk. Crude from this region is light and sweet, making them ideal for the refining of diesel fuel, gasoline, and other high-demand products. And because the supply is waterborne, it’s easy to transport to distant locations. 

Countries that come under Brent crude are Europe, Africa and the Middle East.

Brent crude’s price is used as benchmark to set prices in the oil market.

Roughly two-thirds of all crude contracts around the world reference Brent Crude, making it the most widely used marker of all. Brent futures are available on ICE Futures Europe.

2) West Texas Intermediate (WTI crude)

WTI refers to oil extracted from wells in the U.S. and sent via pipeline to Cushing, Oklahoma. The fact that supplies are land-locked is one of the drawbacks to West Texas crude as it’s relatively expensive to ship to certain parts of the globe. The product itself is very light and very sweet, making it ideal for gasoline refining, in particular. It is used as benchmark for oil prices in United States. It is more sensitive towards the American development. WTI contracts are sold chiefly on the New York Mercantile Exchange (NYMEX).

3) Dubai

A “basket” product consisting of crude from Dubai, Oman or Abu Dhabi, it’s somewhat heavier and has higher sulfur content, putting it in the “sour” category. Dubai/Oman is the main reference for Persian Gulf oil delivered to the Asian market. This Middle Eastern crude is a useful reference for oil of a slightly lower grade than WTI or Brent. Oman Crude Oil Futures Contract (DME Oman) has been marketed on the Dubai Mercantile Exchange since 2007.

Now the question arises,

How to Trade in Crude Oil?

One can trade in Crude Oil in 6 commodity trading markets(India) :

1. Multi Commodity Exchange – MCX.
2. National Commodity and Derivatives Exchange – NCDEX.
3. National Multi Commodity Exchange – NMCE.
4. Indian Commodity Exchange – ICEX.
5. Ace Derivatives Exchange – ACE.
6. The Universal Commodity Exchange – UCX.

Let’s understand few terms of Derivative market to understand things better.

Crude Futures: Crude oil futures are futures contracts in which buyers and sellers of oil coordinate and agree to deliver specific amounts of physical crude oil on a given date in the future.

Crude Options: Crude oil options are in fact options on futures. Both American and European types of options are available. American options, which allow the holder to exercise the option at any time over its maturity, are exercised into underlying futures contracts. For instance, a trader who is long on American call/put crude oil options takes long/short position on the underlying crude oil futures contract.

Key Differences

Options contracts give holders (of long positions) the right, but not the obligation, to buy or sell (depending on whether the option is call or put) the underlying asset. Thus, options have a non-linear risk-return profile that is best for those crude oil traders who prefer downside protection. The most a crude oil option holder can lose is the cost of the option (premium) that is paid to the option writer (seller). Futures contracts, however, do not give such an opportunity to contract sides, since they a have linear risk-return profile. Futures traders can lose the entire position during an adverse movement of the underlying price.

In contrast to the futures position, the long call/put option positions are not margin positions; thus, they would not require any initial or maintenance margin, and furthermore would not trigger a margin call. This in turn enables the long option position trader to better sustain price fluctuations without any additional liquidity requirement. The trader must have enough liquidity to support short-term price fluctuations. Long option contracts help to avoid this.

Traders have the opportunity to collect premiums by selling (thus assuming high risks) crude oil options. If traders do not expect the crude oil prices to strongly change in any direction (up or down), oil options create an opportunity for them to earn a profit by writing (selling) out-of-the-money oil options. Recall that a short option position collects the premium and assumes the risk. Thus, selling out-of-the-money options, be it call or put, will enable them to profit from premium collection should the option end up out-of-the-money. Futures contracts by nature do not include any upfront payments, therefore they do not offer this type of opportunity to the traders.

Participants

1)  Traders – who are speculators and just make investments with a motive of earning profits. They do intend to purchase oil in physical.

2)  Buyers – who make purchase of oil for actual use. These are refineries, airlines.

3) Hedgers – protects producers from market declines by allowing them to lock-in a certain price for their oil. One way a company can hedge output is by buying a floor on the price (called a put option) and then offsetting the cost of that floor by selling a ceiling (a call option). To cut costs even further, a producer can sell what’s known as a subfloor, a put option that’s much lower than where prices are currently trading. That three-pronged approach is known as a three-way collar and it functions well when oil’s moving sideways but can leave producers vulnerable if the market bottoms out.

So what happened to crude oil (mainly discussing about WTI crude), why did the crude oil prices fall to negative all of a sudden?

The above chart shows clearly that on 20th April 2020 the crude oil (WTI) prices fall to -$40.32

Let’s now understand how did this happen.

As due to Corona, virus spread across the globe. As lockdown has made the global economy to a stop entirely leading to a drastic fall in the demand of crude oil.

We know when DEMAND decreases and SUPPLY remains same it will lead to a downfall in the prices.

This is true!

But this isn’t the major reason.

We all know that extracting crude oil from Earth surface costs a huge amount of investment. If the oil extracting machineries are stopped to control the supply, it will cost double the amount of investment starting that machinery then setting up a new oil well for extracting oil.

Different nations kept on producing crude oil and all the storage tanks, pipelines available for storage got filled up.

So, now the buyers who had purchased May futures of WTI crude had to either sell the crude futures to an available buyer or they had to physically purchase the crude on 20th April (being monthly expiry of Commodity futures).

No buyer were available to them who could buy the futures, so unfortunately they had to reduce the prices which even went to -$40.32 and settled at a discount of $37.63 a barrel. It means money was being offered to the buyers for buying futures instead to taking payments from them.

This was only for a shorter period and now the June futures are being traded positive.

This has happened first time ever in the history. 20th April 2020, would be remembered for long. Even Commodities King Jim Rogers got it wrong :

Link : Video on Crude Oil

Special thanks to Pooja Yadav in compiling this article. Hope you all liked reading it. Feedback will be appreciated. Thank You!

Articles & Case study on Value Investing : Jet Airways, VHL, Dhunseri Investments, NBI Finance, Ponni Sugars(Erode), Lupin!

Case Study on Options : Techno - Derivatives, Effective Option Trading

Connect on my Facebook Page : Varun Aggarwal

Free Telegram Channel for updates : Link

Twitter : Link

Your feedback is important, don't forget!