One of the most interesting commodities to trade in is crude oil and it has quickly become the commodity of choice for traders big and small.
That’s a bit surprising considering crude oil is fairly exotic for Indians – hardly anyone has seen it in physical form – and its pricing in US dollars doubles the risk of trading in it since a trader has to concurrently take a call on the currency rates. Added to that, India is not a major producer or consumer on the world stage, what with a handful of countries producing a large chunk of it and another handful being the majority consumers. In fact, mysticism about what affects its price is what makes it a preferred commodity for traders and speculators worldwide and ensures regular interest in the futures trading.
Also, it is the most crucial energy source and wars have been fought over it - and continue to be. Secondly, it is news sensitive, which makes it very price volatile and hence a trader’s delight. One of the key reasons for the rise in oil prices in the last one year is the continued geo-political tension in oil producing regions like the Gulf and Nigeria.
In addition, global prosperity (world GDP growth is 4.5% compared with 2.5% just four years ago) has led to strong global demand and limited spare oil production capacity. Demand is surging, thanks to strong and sustained economic growth, mainly in Asia and supply is struggling to keep pace.
Unexpected supply disruptions have aggravated the situation, creating an atmosphere of shortage. And the fact that the oil-rich nations are havens for political instability only clouds the picture further.
Currency exchange rates also influence the situation. The weakness of the dollar prompts the producers to hike prices to keep their income at higher levels. It may be said, though, that when prices go down, the reverse is equally true and the opposite of all these factors get highlighted.
Are current prices too high? Is it a bubble? Are we being ripped off by arm twisting by oil producing countries? Not necessarily.
Adjusted for inflation, the price of crude oil in 1980, at the height of the Iran-Iraq war, would be about $102 per barrel. Since then, demand has gone up. Besides, spare global capacity, i.e. the amount of oil that can be brought to the market quickly, is at its lowest level in three decades. Refining capacity is also a bottleneck and will keep crude prices higher as hardly any new refineries were planned after significant dips in its prices in the late 90s. The new refineries being set up to meet today’s demand will go on stream after another couple of years.
Another important factor is the Reserve Replacement Ratio, a term which simply measures the ratio of oil pumped out compared to new oil reserves found. Currently, the ratio is less than one, indicating that more oil is being consumed in the immediate term than is being discovered - which again creates a feeling of energy insecurity.
The direct effect on our daily lives has been significant - higher fuel prices have contributed to all-round inflation. Since there have been no additions to refining capacity in the last several years, refineries have raised their margins. Limited competition and governmental regulations also explain some of the inefficiencies that prevent lower prices. Add taxes and you know why filling petrol in your car costs you a small fortune.
The rise in prices has led to more money being pumped into oil exploration, technologies to up output even from marginal fields and new investment into refineries, besides political pressure on exporting nations to produce more. High oil prices at a point become counter-productive if they lead to degrowth in user countries. So, there will either be additional supply or demand will be adjusted to bring prices to acceptable levels.
Given today’s growth scenario, it is unlikely that crude prices will come down in a hurry. In fact, driven by a weak dollar, high demand and global insecurity, we could look at prices up to 25% higher within 2008.
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Investing or trading in crude is a high-risk-high-return strategy at the best of times.
High correlation with international prices, dynamic news flows, reasonable lot sizes, good trading interest and liquidity help make it an interesting tradable commodity in the markets. Extensive coverage in our media has ensured good depth and liquidity, making it and ideal commodity to start trading for first-time traders as well.
The writer is head-commodities.
