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) 

The biggest FX play of 2014: EUR/USD.

8 months later and the euro can only buy 80% of the dollars it could back in May 2014, but what has been behind this huge move? And where can it go in 2015?

1    Why the big move?

The big move has been based on investors views of the two differing economies and what stage they are at in their economic development post crisis. On the Europe side, investors have seen a loosing of monetary policy with ultra-low rates and an asset buying programme of 60bn euros a month (QE). Overall a very dovish central bank. But then these investors look to the USA and see a completely different story; GDP @ 5%, inflation around 2% (pre-oil shock) and a central bank feeling hawkish with a plan to raise the rate maybe in 2015 and also turning QE tap off in the bank end of 2014.

This complete divergence is why investors have shifted their euros to dollars in the classic carry trade. 

Here in this chart you can see the currency fall from a high of 1.3930 to a low last week of 1.1116.

Along with this clear interest rate/economics trade, there has been another big factor which was the Swiss National Bank unpegging its currency to the euro, in a clear signal that shows the Swiss cannot realistically value their currency at the devalued euro. This moved the euro even more against the dollar.

1   Where can the currency go in 2015?

This is the big question on currency traders’ minds across the world. From a fundamental view point, nothing has changed. Europe is still in the position it is and has only just announced its QE program, suggesting there is much more devaluation let to play. Also the Fed still is to raise the rate which would again see great strengthening on the US dollar. In fact the dollar is set to have a great year in 2015, as it outstrips all major economies in terms of growth.

The problem investors see is whether all this information has already been priced in. All of this information is already available to the market and investors have traded accordingly, therefore the question is with no new information, there should be no reason to see a big devaluation.

On the psychological view point (which is one of the major influences in the currency markets, especially medium-term) when there has been news flow all pointing towards one trend, a small piece of information in the opposite way can cause a big move.

Overall I believe this will still be down trending in 2015. Not at anywhere near the same pace, however there are too many expected/potential events that will happen in 2015 that make me bearish the euro against the dollar:

       Fed rate rise?

2       Continued Deflation in Europe?

3      German recession?

4     Uneffective QE?

5       Greece exit worries again?

6       Increased GDP in US?

Therefore on my recommendation I would hold this trade over the next year until something fundamentally changes at which point will be the time to re-assess.