The inspiration for trading a product is essentially determined by the supply and demand situation of that product. There must be a motivation to source the product and equally there has to be a gain for selling the product. This is referred to as arbitrage, which accelerates the initiation of trading interest. The key element in this situation is the price and its impact on the supply and demand of the product.
Oil & Gas an an Exclusive Proposition
When we talk about oil and gas products, it is interesting to note that in the short term the demand for some products, such as gasoline, is almost static. A consumer doesn't drive their car twice as much simply because the price of gasoline is low. The same holds true for the opposite situation when the price increases; the consumer is not going to stop using their car either. Hence, the elasticity of demand is virtually nonexistent in the short term for petroleum products.
On the supply side, the situation is the same because oil and gas companies do not reduce production due to a short term dip in oil prices. Also, because oil and gas is a process industry, shutting down the plant due to daily price variance is simply not feasible. It is possible to influence the production parameters so as to increase or decrease product outputs in a refinery, but not to a large extent. However, in an oil exploration environment the main objective is to maximize raw crude oil production because huge investments have already been made.
The cost of pumping a marginal barrel of oil is comparatively low once the capital expenses of prospecting and building associated infrastructure has been incurred. An oil field will cost roughly the same to operate whether it is producing at half capacity or at full capacity. Given this, once producers have an oil field in place, they will tend to pump at their maximum sustainable rate. Of course, there is always some degree of flexibility – old wells can be uncapped and scheduled maintenance can be postponed so as to meet the increasing demand.
But in the long run the situation is very different and that is what makes the oil and gas industry a special situation for trading. Long-term expectations of a price rise will cause both the demand and supply situation to be dynamic and change drastically. Also, events outside the industry's control can trigger a high voltage scenario in the market. For instance, the oil shock of the 1970s caused the oil supply curve to shift fundamentally to the left, but over a relatively longer period of time the demand curve also shifted to bring in a new demand supply position at the global level.
Geo-political Dynamics and Oil & Gas Trading
The Arab oil embargo during the 1970s had a significant impact on the oil and gas industry and in particular the trading segment of the industry. During the Yom-Kippur war, many western nations took the side of Israel, and OPEC declared a reduction in supply. Thus, for any given price level, less oil was supplied to the market. This caused the supply curve to shift to the left, and because the supply had to be balanced out in the market, prices rose dramatically. The price of Saudi light crude jumped from under $3 a barrel in 1971 to almost $40 a barrel by 1980. However, oil consumption did not decrease immediately to match the new supply position; on the contrary it continued to rise after the first oil shock of 1973. Then, from a peak in 1976, consumption began to fall to almost 15% from its highs and continued falling even after the oil prices peaked in 1980 and the world economy slowly started showing signs of recovery. Oil and gas trading thus played a key role in stabilizing the long-term effect of the global situation by creating equilibrium between supply and demand.
The supply did not improve overnight to negate the impact of the rising prices. It took a significant period of time (3 to 5 years) to create new capacity by building new infrastructure, exploring, and adding refining capacity either through debottlenecking or bringing new production assets on line. This was facilitated by reinvesting the accumulated revenues caused by the sustained higher prices.
World Events vs Crude Oil Prices
World events affect crude oil prices. Every time a major event occurs, the crude oil price is the first casualty and the price skyrockets only to be corrected when the supply side strikes a balance by enhancing production.
The Concept of the Clearing Price
The lesson that oil and gas traders learned during the oil crisis was a basic tenet of trading, i.e., oil trading is unique because the supply and demand situation does not have an immediate impact on the strategic direction. So, what matters for the traders? What matters is the clearing price, or the price at which either supply or demand would be cleared out in the market in response to a given situation.
In the long run, higher oil prices tend to encourage consumers to either reduce energy consumption or shift to other forms of energy. Similarly, investment either in challenging areas for exploration or in developing new technologies will result in greater quantities of oil or synthetic crude coming into the market. Each boom in the oil price propagates the seeds of its own annihilation in the long run.
The Magic of Spot Transactions
Prices in spot markets send a clear indication about the supply/demand balance. When a company temporarily has too much supply (perhaps due to excess capacity) after meeting its own needs, it offers some for sale in the spot market. Similarly, if it needs additional volumes to meet a demand spike, or because supply is unexpectedly reduced, it will purchase oil on a cargo-by-cargo and shipment-by-shipment basis. This market is known as the "spot market." In recent years, the growth of merchant refiners has depended on viable spot markets. These independent refiners manufacture products not to fill their own marketing requirements but to sell the products to the third-party highest bidders.
In the dynamic situation prevailing today, trading in petroleum products requires a robust understanding of the market fundamentals and a proper reading of the geo-political situation. Even experts in oil and gas trading periodically refresh their understanding of the market's nuances in order to gain insights into the market drivers and reformulate their approach to the trading business.