DR.CHENJIAZI ZHONG

Crude Oil

Oil has been the driver of industrialization and modernization. Over the past 30 years, daily oil consumption has risen by over 30 million barrels. Asia has accounted for more than half of this growth in demand, which would climb considerably as its automobile industry expands.

On the supply side of crude oil, one promising area that holds potentially large deposits is the northern Arctic regions. Another source is from tar sands, especially in Alberta, Canada. Additionally, Brazil has made various major oil discoveries; while the reserves could be decent, the oil is in deepwater and will require expensive technologies to penetrate the ocean floor. Namely, the world’s largest crude producers include Saudi Arabia, Russia, the U.S., Iran, and China. According to many economists, growth in world oil production will be limited, as key world oil producers are approaching a peak in their ability to produce oil; however, OPEC member countries so far do not have independent audits on their oil reserves, so it is hard to tell when these countries will reach capacity. On the other hand, as countries rapidly grow their industrial sectors, oil consumption keeps being driven up, and it is anticipated that demand for oil could outstrip supplies within the next few years.

Crude oil is the most actively traded commodity space. Two main types of crude oil traded on the NYMEX are light sweet crude oil and Brent crude oil. The former is from Cushing, Oklahoma; refineries prefer light sweet crude oil because it has low sulfur content and yields a large volume of high-value products, such as gasoline and heating oil. Brent crude, on the other hand, is based in North Sea. Both light sweet crude and Brent crude futures contracts call for delivery of 1,000 barrels (42,000 gallons).

There are many different ways to predict oil prices; one is to estimate the spare capacity, which is primarily based on OPEC members. The rule is that whether the spare capacity is 5 percent or less than the daily global oil consumption, then there is likely a rise in crude oil prices.

The main categories of oil companies are upstream and downstream, in which upstream includes exploration companies, and downstream is the oil services industry. In addition, there are drillers and refiners.

1. Exploration companies are often small ones that spend years trying to find lucrative deposits of oil; oil exploration is a high-risk business. Because of this consideration, industry expertise is the single critical factor in this business.
2. Oil services operation heavily relies on sophisticated software, 3D analysis, seismic surveys, and drill bits.
3. Drillers own properties rights (land rigs or submersible rigs) and extraction rights. A key metric for drillers is the day rates, which are the fees for drilling on a daily basis. If there is a steady climb, profits should begin to grow; another indicator is the rig utilization rate, whereas the higher the rate, the more revenues and profits a driller is likely to generate. Drillers business depends on the quality of rigs, and their locations.
4. Refiners turn oil into gasoline, fuels, and chemicals. The refiners industry is consolidated, and due to heavy government regulations, it is extremely difficult to build a new refinery.

Gasoline/Unleaded Gasoline

Gasoline is the biggest product derived from crude petroleum. It is the single-largest-volume refined product sold in the U.S.

Gasoline consumption is growing worldwide, especially in fast-growing economies; demand growth in the U.S. has been less than that of developing nations; gasoline refiners have adopted increasingly efficient technologies in the recent years, so they produce more gasoline from each barrel of crude oil processed.

The global gasoline market is very competitive and subject to intense price volatility; beyond that, different regions have varying access to gasoline suppliers, so prices vary. Keep in mind that due to the close relationship between unleaded gasoline and crude oil, the prices often follow each other, except for during events, e.g., hurricane.

The most heavily used risk-management tool in the U.S. gasoline markets is the NYMEX Division New York Harbor unleaded gasoline futures contract. The maximum price fluctuation of unleaded gasoline futures contracts is $0.25 per gallon for all calendar months. The contract specifications are strict for emissions controlling purpose. To ensure that the terms and conditions of the gasoline futures contract continue to mirror the cash market, NYMEX maintains close agreement with officials and continues to evaluate changes in the regulations. In the meantime, alternative fuels are evaluated, such as ethanol, to reduce the dependence on oil imports from the Middle East, as well as to reduce pollutants.

Heating Oil

Heating oil represents approximately 25 percent of the yield from a barrel of oil, secondary to gasoline. The primary use includes energy for furnaces, much of it for homes. It is stored in tanks, which are typically in basements or garages. Refineries produce heating oil as part of a distillate fuel oil product, which includes diesel oil and heating oil. The main regions in the U.S. that rely on heating oil are in the northeast.

The primary determinant of heating oil is weather: a rapid change to cold weather can deplete heating oil supplies more quickly, which puts pressure on refineries, delivery systems, remaining supplies, and therefore drives up prices. It is important to note that approximately 40 percent of the cost of heating oil is based on the price of crude oil, in another word, if crude increases by $1, the cost of heating oil will up $0.025.

The fact that heating oil contracts trade for 18 consecutive months means that traders can execute strategies that apply to two winters.

Natural Gas/Liquefied Natural Gas

Natural gas consists mostly of methane and is found alongside fossil fuels and coal beds; after being drilled, natural gas is usually transported through pipelines, which is expensive. As an alternative to natural gas, liquefied natural gas takes up 6/100 the volume of the regular form, making it much easier to ship with tankers. Because of this quality, some major energy companies have started investing in LNG distribution.

Scientists believe that natural gas is formed from the compression of organic matter deep inside the earth, and found in rock and shale formations – the deeper the deposits are, the greater is the percentage of natural gas relative to the amount of oil.

In the short run, the price of natural gas is impacted by weather, and it tends to be higher during winter and summer when the usage is high. However, many large consumers of gas, like utilities, have the ability to switch from gas to other fuels, like coal, so they are likely to use the alternatives when the gas prices are more expensive. Deregulation of the natural gas markets has pushed price risk and competition from the producer and reseller level down to the actual natural gas consumers and investors.

Reference

How To Trade The Precious Metals, Energy, Grain, and Tropical Commodity Markets, by Ronald C. Spurga, 2006