Buying Oil Investments – Chapter 5: Trading in Oil Futures: (The impetus of the market sentiment)

This is chapter number 5 out of 12. Read the rest:

Read Buying Oil Investments – Chapter 1: Introduction
Read Buying Oil Investments – Chapter 2: Getting started in oil investments
Read Buying Oil Investments – Chapter 3: Factors which affect the price of oil
Read Buying Oil Investments – Chapter 4: The determinants of Oil Prices

As mentioned earlier, there are two main factors which affect the prices of oil. These are the supply & demand for oil itself and the market sentiment surrounding the oil market. The market sentiment of the oil market is largely manifested and shaped in the oil Futures market. If we recall back to an earlier chapter, an oil Futures contract is an agreement between two parties to take delivery of a fixed quantity of oil at a date set for the future at a specific price. This allows use of the commodity to hedge the price to ensure the supply of the commodity at a fixed and certain price.

Thus future contracts traders are also know as “Hedgers” as they hedge the risk of price uncertainties with the futures contracts. On the opposite end of the trading spectrum is another class or traders known as the “Speculators”. They actually represent around 97% of the volume traded on the commodities exchange.

Speculators are in the trading of futures contracts purely to make above average profits. They assume the risks which hedgers are trying to rid themselves off and they thrive on price uncertainties. If a speculator holds the belief that the oil price is going to rise, they will then purchase the oil futures and wait for the price to rise. They stake out a “long” position in the market. Once the price has risen high enough, they will then sell the Futures contract at the higher price and realize their profits from the price movements. The opposite is true in a bearish market. They will instead take a short market position.

The main reason why speculators are able to “move” the price of commodity based on mere market sentiment is because of the sheer volume which they trade in. with margin trading, they are able to leverage their trades many time over.  Thus, when enough speculators participate in  a trade based on the same belief, the market will begin to move in the direction of the market position that they staked out at.

The spike in oil prices in 2008 was actually a result of speculative demand. In reality, out of 27 barrels of oil that are traded in the commodities exchange, only one barrel is for consumption in the USA. This indicates that the rest of the oil traded is just speculative demand. It is for this reason that on 22 Sept 2008, the price of oil jumped by $25 within a single day. There was no news on that particular day which reported a disruption in the supply of oil. Thus, the only viable explanation which could have caused such a big jump in price was pure speculative demand.

Bearing this incident in mind, we can conclude that oil prices are not purely affected by the laws of supply & demand. The current market sentiment also plays a huge role in determining what the price of oil is going to be.

Read Buying Oil Investments – Chapter 6: Investment Options
Read Buying Oil Investments – Chapter 7: Exchange Traded Funds
Read Buying Oil Investments – Chapter 8: The Risks Of Investing In The Oil & Gas Industry
Read Buying Oil Investments – Chapter 9: Advantages Of Investment In The Oil & Gas Industry
Read Buying Oil Investments – Chapter 10: Investments in Gold versus Oil
Read Buying Oil Investments – Chapter 11: Peak Oil
Read Buying Oil Investments – Chapter 12: Conclusion