The inspiration for trading of a product is essentially determined by demand supply situation of that product. There has to be an interest in sourcing the product and equally there has to be a will to sell the product for a gain. This is referred to as arbitrage, which propels the initiation of trading interest. The key element in this situation is the price and its impact on the demand supply situation of the product.
Oil & Gas an exclusive proposition
When we talk about oil and gas products, it is interesting to note that in short term the demand for gasoline, for example, is almost static simply because if the price of gasoline is low, one will not run his car twice for his day to day use. The same holds true in opposite situation when the price goes up, he is not going stop using his car either. Hence, the elasticity of demand is simply nonexistent in the short turn for petroleum products.
On the supply side, the situation is the same as oil and gas organizations do not reduce production due to short term dip in prices. Also, since it is a process industry, shutting down of the plant due to daily price variance is simply not feasible. It is possible to influence the production parameters so as to increase or reduce product outputs in a refinery situation but not to a great extent. However, in an oil exploration environment the main objective would be to maximize crude oil production as huge investments have already been done.
The cost of pumping a marginal barrel of oil is comparatively low, once the capital expenses of prospecting and building associated infrastructure is been incurred. An oil field will cost roughly the same to operate whether it is producing at 50% of capacity or at full capacity. Given this, once they have an oil field in place, producers will tend to pump at their maximum sustainable rate. Of course, there is always some degree of flexibility such as 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 control of the industry can trigger a high voltage scenario in the market. For instance, the oil shock of the 1970s which 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 anew demand supply position at the global level.
Geo-political dynamics and Oil & Gas trading
Oil shock during 1970s had 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 cutting of supply. Thus, for any given price level, less oil would be supplied in the market. This caused the supply curve to shift to the left and since the supply had to be balanced out in the market, the prices rose dramatically. The price of Saudi Light crude jumped from under $3 a barrel in 1971 to almost $40 a barrel by 1980. The consumption of oil however did not reduce immediately to match the new supply position and 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 in1980 and the world economy slowly started showing signs of recovery. Oil & Gas trading thus played a key role in stabilizing the long-term effect of the global situation by creating equilibrium between supply and demand of the oil products.
Supply of oil products did not improve overnight to negate the impact of the rising prices. It took significant period of time, i.e., between 3-5 years to create new capacities in building new infrastructures, exploration, additional refining capacity either through debottlenecking or new production assets. This was facilitated by ploughing back the accumulated revenues caused by the sustained rising prices.
World events Vs Crude prices
World events affect crude oil prices. Every time a major event occurs, the crude oil price is the first casualty and the price goes up intensely only to get corrected when supply side strikes a balance with enhanced production.
Concept of clearing price
The lesson oil and gas traders learnt during crisis times were a basic tenet of trading, i.e., oil trading is unique because demand and supply situation does not matter as their impact on strategic direction of the industry is less relevant. So, what matters for the traders? What matters is the clearing price, i.e., the price at which either demand or supply would be cleared out in the market in response to a given situation. In the long run, high oil prices will tend to encourage consumers to either reduce energy consumption or shift to other forms of energy. Similarly, investment in either 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.
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 after meeting its own needs, it offers some quantities 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 “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 fluid situation prevailing today, trading in petroleum products requires robust understanding of the market fundamentals and proper reading of geo-political situation. Even current experts in oil and gas trading prefer to revisit their understanding of the market nuances to ascertain their insight into the drivers of the market and reformulate their approach to trading business.