UNDERSTANDING

THE CORE
FUNDAMENTALS
FOR TRADING OIL
THE FUNDAMENTALS OF TRADING OIL
UNDERSTANDING THE CORE FUNDAMENTALS FOR
TRADING OIL
DailyFX Research Team

Table of Contents
Understanding the Core Fundamentals for Trading Oil ................................................................. 3

The Producers and the Consumers ....................................................................................................... 5

Oil is Highly Sensitive to Supply Changes – It’s Elastic!....................................................................... 5

Oil’s Relationship to Other Asset Classes ............................................................................................. 6

How Do Oil Price Swings Impact Policy?............................................................................................... 8

Recent History: Technology Improvements in United States Drive Supply Glut ................................. 9

Recent History: OPEC’s Lack of a Meaningful Response..................................................................... 9

In Summary............................................................................................................................................ 11

Disclaimer..................................................................................................................................12

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DailyFX Research Team

Understanding the Core Fundamentals for Trading Oil

As with most markets, the fundamental motivation behind crude oil is not static. Themes dictating
the rise and fall of the energy market’s benchmark grade rotate from general risk trends to geopolitical
developments to classic supply-and-demand depending on the circumstances. Yet, where catalysts
change on a regular basis, the underlying trends only temporarily wane for influence until the winds
shift back into their favor. If you want to develop a functional and big-picture understanding of the
fundamentals driving crude prices, it is best to start with supply and demand.

When you open up an “Intro to Economics” textbook, one of the first discussions you’ll encounter
covers ‘supply and demand’ alongside ‘elasticity.’ Supply and demand are simple enough concepts
on the surface, so we’ll start there before we dive into the specifics to oil markets. Market participants
from traders (short-term), to investors (long-term), to economists (observers) study supply and
demand to determine how changes in production impact prices. There are, in effect, two sides
determining price: buyers (demand) and sellers (supply).

Price simultaneously reflects the value to the buyers and the cost to sellers: demand reflects the
ability and willingness of buyers to purchase a given quantity of a good or service. In textbook
language supply reflects the ability and willingness of sellers to offer a given quantity of a good or
service. For different levels of prices for goods, both demand and supply will differ. These
relationships yield what is known as the supply and demand curve.

Chart 1: Basic Supply & Demand Curve

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As demand rises, the law of supply dictates that sellers will offer more of their goods or services to
the market in order to capture the surplus the additional demand creates. Over time, as sellers push
up prices, the law of demand tells us that buyers will want less of that good or service. In response,
sellers will eventually lower prices. This constant push and pull is a market’s eternal search for the
equilibrium price for a good or service. When a market is in equilibrium, it is said that buyers have
reached the maximum price they’re willing to pay for a good or service at the lowest level sellers are
willing to accept for said good or service.

Chart 2: Supply and Demand Curve Shifts

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UNDERSTANDING THE CORE FUNDAMENTALS FOR
TRADING OIL
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The Producers and the Consumers

Oil markets, like any other market that encompasses goods and services, can be broken down into
the binary supply and demand relationship. Yet oil markets are not necessarily ‘normal’ as theory
would ascribe. On one hand, demand for oil comes from many sources: individual consumers,
businesses, and governments. The demand side consists of literally hundreds of millions, if not
billions, of sources each day. Oil and its byproducts (think petroleum) make: fuel for cars, fuels for
heating and electricity generation, asphalt for roads, and even plastics.

The supply side is not as deep as the demand side; that is, there are only a handful of significant
sellers relative to the hundreds of millions of buyers. One of the largest producers is a collective
referred to as OPEC (Organization of Petroleum Exporting Countries) accounting for 34% of global oil
supply. Operating as a cartel, OPEC has one main goal: coordinate production efforts in order to keep
oil prices elevated and stable, to the benefit of its members. Other major oil producers historically
include Canada and Russia, but in recent years – especially since the Global Financial Crisis – the
United States has emerged as a significant supplier in energy markets.

Oil is Highly Sensitive to Supply Changes – It’s Elastic!

Adding a layer of complexity to this discussion on supply and demand is the concept of ‘elasticity.’
What is elasticity? In the context of the goal of this guide, elasticity is how sensitive supply or demand
for oil a good or service is to changes in price. The more sensitive the price of a good or service is to
a change in supply or demand, the more elastic it is said to be. One of the few places that this theory
translates to well into the real world is in oil markets, perhaps the most elastic tradeable commodity.

If oil is an elastic good, then it is very sensitive to changes in supply and demand. For all intents and
purposes, demand is generally stable – global growth rarely oscillates to extremes of exceptional
expansion to crushing recession. Instead, oil is largely effected by swings in supply – or, at least,
perceptions of changing supply levels. In recent years, oil has entered what is referred to as a ‘supply
glut’ – a state where supply exceeds demand by a significant margin. This is mainly due to
technological developments out of the United States.

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Chart 3: OPEC Production versus US Crude Oil Production (June 2012 to June 2017)

Oil’s Relationship to Other Asset Classes

Generally speaking, oil prices tend to remain positively correlated with assets that track growth trends
which fundamentally is the foundation for growth in returns from the financial system. The first asset
that may come to mind is equities. As a rule of thumb, if the global economy is growing rapidly, there
will be greater demand for oil and likewise the value of equities will increase as that expansion
contributes to revenues and profit sharing. When the global economy is slowing, oil tends to slump
as oil demand fades, and equity values tend to fall reflecting pessimism over growth.

Chart 4: US Real GDP (Year-over-Year) Versus US Crude Oil Spot Price (1986-2017)

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There are certainly periods of time when oil prices and equity markets don’t have a positive
correlation. These are typically times when sentiment is not overwhelming clear and/or during swells
in geopolitical tensions. Investors, when faced with sharply rising oil prices due to increased
geopolitical risk, tend to sell equities as concerns that growth will slow as global trade tensions flare
up. If higher oil prices are sustained, then inflation can rise more than expected, forcing central banks
to raise rates, which can pressure equity markets even more.

While many currencies are not overtly impacted by oil prices, there are several that are. The two major
ones are the Canadian Dollar and the Russian Ruble. Oil constitutes a significant portion of both
Canadian and Russian exports, so these currencies tend to track the value of oil. For example, when
oil prices go up, American buyers need to pay more Canadian Dollar to settle their accounts; in turn,
demand of the Canadian Dollar relative to the US Dollar increases, pushing down the value of
USD/CAD.

Chart 5: USD/CAD Exchange Rate Inverted Versus US Crude Oil Spot Price (2007-2017)

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How Do Oil Price Swings Impact Policy?

Policymakers around the world, particularly those in central banks, care very much about oil price
swings – especially when oil rallies quickly. The laws of supply and demand are in play here. An
exogenous shock like a sharp increase in oil prices can have dramatic effects for the broader
economy (such as the 1970s oil crisis in the United States). When oil prices rise unexpectedly,
inflation (loosely the cost of living) increases, which hurts consumption. Not only do policymakers
have to raise interest rates in response to higher inflation – which dampens growth as credit becomes
less freely available – the crimp on consumption can in turn cause aggregate demand for to fall. When
aggregate demand in an economy falls, growth isn’t as strong, which has negative implications for
employment and other critical areas in a negative cycle. On the flipside, oil prices that fall rapidly can
lead to inflation to fall, which allows central banks to keep policy looser for longer. Loose monetary
policy in the United States after the Global Financial Crisis in turn helped spur on technological
improvements in oil production, which have lingered today.

Chart 6: US Consumer Price Index (Year-over-Year) Versus US Crude Oil Spot Price (1986-2017)

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Recent History: Technology Improvements in United States

Drive Supply Glut
In an otherwise dour economic environment in the post-Global Financial Crisis years, a significant
amount of investment was poured into developing technology for how to extract oil from otherwise
untapped resources in the United States. This new technology was called horizontal drilling, or what
is commonly referred to as ‘fracking.’ This changed the oil market forever. The United States, once
the world’s largest importer of oil, became a net exporter. The United States no longer depends on
the rest of the world for oil, and this is primarily driven by the investments that flowed into drilling
technology. Almost overnight, the United States became a global player in oil markets after a four
decade hiatus: the first US tanker carrying oil to Europe docked in Marseille, France on January 20,
2016, and US exports have steadily climbed since.

A new influx of supply into a balanced market has collateral repercussions. This new source coming
online means the supply and demand picture for that market is markedly altered. For prices to stay
stable, we need either a reduction in supply from other market participants, or a marked increase in
demand. As we know, demand is generally stable over time. In turn, it was a near-guarantee that the
rising supply would provoke a sharp turn lower in prices, especially if OPEC didn’t curtail their
production.

Recent History: OPEC’s Lack of a Meaningful Response

OPEC’s actions in recent years would suggest that they were not as greatly concerned with turning a
profit as they were with retaining market share. Amidst falling prices, OPEC relegated its pricing power
as an oligarchical force in the market in favor of pumping more oil until the end of 2016. Around June
2014, it was made clear by Saudi Arabia – which accounts for approximately 30% of OPEC’s total
daily output – that it had no intention of cutting supply.

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TRADING OIL
DailyFX Research Team

Even after agreeing to a production cut for the first time in eight years in November 2016, low oil
prices sent shockwaves across major oil producers. Despite the production cut agreement, oil prices
remain are below both the fiscal breakeven (the price of oil required to balance the budget) and the
external breakeven (the price of oil required to balance the current account) of many OPEC countries.
Many accusations pointed fingers at OPEC with blames of keeping supplies high in an effort to drive
American shale producers out of business. As US shale extraction technology has improved its
efficiency further, oil has struggled to gain meaningful footing. Following the crash from $105 per
barrel in June 2014 to $26 per barrel in February 2016, oil prices struggled to rebound with price barely
able to return to $50 per barrel by mid-2017.

Chart 7: US Crude Oil Spot Price (2007-2017)

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TRADING OIL
DailyFX Research Team

In Summary
Like any other traded good or service, oil markets are governed by the laws of supply and demand.
As supply increases, prices tend to drop; as supply decreases, prices tend to rise. On the other hand,
as demand increases, prices tend to increases; as demand decreases, prices tend to fall. In the oil
market, demand is more stable than supply, as demand is represented by hundreds of millions of
participants (consumers, business, governments, etc.) while supply is represented by only a handful
of meaningful producers (mainly OPEC, Canada, Russia, and now the United States). Overall, the
United States’ increasing oil production and disagreement among OPEC members over how to
implement production cuts will be an overarching theme for the foreseeable future (at least the next
five years). US oil production will continue to increase, regardless of what OPEC does. Barring
extended periods of geopolitical tension, it seems that the global supply glut will remain the most
important factor in determining the direction of oil prices for a long time.

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TRADING OIL
DailyFX Research Team

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