Introduction To Financial Markets: Oil

Welcome to my short series on the financial markets! 

Here I will explain how simple economic theories are used in a way to understand, predict and profit from the markets. 

If you have limited exposure to the markets but have a good mind for economics, this is the perfect introduction for further interest and learning. 

Hope you enjoy and thank you for reading. 

Energy and in particular crude oil moves with global demand and supply of the product. With OPEC producing 44% of the world’s crude oil, OPEC is the main determinant of the amount of supply being supplied to the world. If OPEC announces a decrease or increase in production the price for oil (Given demand stays the same) will increase and decrease relatively. The main things that can affect OPEC output include their desire for high oil prices (Acting as a cartel to maintain high oil prices for self-benefit), public conditions within the OPEC countries (For example civil unrest may cause oil plants potentially closing down indefinitely) and exogenous shocks such as plants closing down due to problems.

Along with this, oil reserves play a part in the short-term supply conditions of oil - if there is an underestimation of oil reserves then prices will fall, over estimation will cause the opposite.

Demand for crude is derived from many needs such as gasoline (automobiles), heating oil, diesel, kerosene etc… Ultimately along the supply chain for any good or service, oil is needed. Whether it be in the manufacturing of goods, the long transportation of input goods even all the way to the petrol needed for employees to drive to the workplace. This is why the demand for oil is very much in line with global GDP and output. So oil traders will always consider global demand and production to gauge their demand for oil.

Besides demand and supply, there are also other factors:

Speculative buying and selling is also very inherent in the price of oil, very often the price overshoots the market equilibrium which increases volatility but also creates inefficiency in the price which is a trader’s best friend.

Finally the exchange value of the dollar. Oil is sold in US dollars, therefore if the dollar depreciates it becomes cheaper for foreign countries to buy oil which raises the price of oil in dollars. Therefore there is an inherent inverse relationship between the dollar and the price of oil (When ignoring other factors)