Know the drill | Trade Samaritan

Know the drill

The way one cannot survive without air, food and water, one can barely survive without Oil. Oil has become a basic necessity of today’s world. Oil has innumerable uses and it the most sought after commodity. In order to keep the lamp burning we have to put oil in it.

The way one cannot survive without air, food and water, one can barely survive without oil. Oil has become a necessity of today’s world. Oil has countless uses and it is the most sought after commodity. In order to keep the lamp burning we have to put oil in it.

Oil trading is the most complex of all commodity trading. The consumption and the production patterns are ever changing. With Globalization and World Mobility the demand for oil in the Transportation sector has spiked. It is a war between infinite demands versus finite supply. One barrel of oil is used to make products like Diesel, jet fuel, gasoline, LPG, Propane, heating oil.

On an average one barrel of oil is traded 27 times before it is delivered or consumed. Oil is traded on a regulated Exchange under Commodity Futures. Traders buy, hold and sell what is commonly known as ‘Paper Oil’. Such an excessive paper based trading of oil brings in the price volatility. Let us discuss the Oil Trade from scratch.

Oil reserves (declared) and Oil consumption.

oil-reserves-2012

Country Reserves 2012 (10^9 Barrels)
Venezuela 296.5
Saudi Arabia 265.4
Iran 175
Iraq 151.2
United Arab Emirates 143.1
Kuwait 136.7
Russia 101.5
Kazakhstan 74.2
Libya 49
Nigeria 47

There are about 17 countries substantially blessed with this natural resource and have created oil reserves of their own or linked to OPEC (Organization of Petroleum Exporting Countries). All of 217 countries in the world feed on these 17 countries for their Oil demand.

Share of Total Consumption & Consumption by Sector

oil-demand

 

Region-wise Consumption

Oil Consumption

 

Oil exploration and drilling

Oil is found in the layers of sub-surface and underwater. In olden times, oil wells were dug randomly basis unexplained intelligence and intuition however today we have mechanical and scientific methods of exploring and drilling out oil. Geologists are employed who are able to locate oil through vibrators. Once the presence of oil is established and the site is legally selected for drilling, an oil rig is set up wherein a hole is dug and with the use of equipment, oil is extracted. In case of underwater extraction, oil wells are dug under the sea bed. Setting up an oil rig under the sea is extremely challenging and requires huge investment in production equipment. Environment poses several other hurdles such as several meters of addition to the well and water pressure. It also requires a system to separate oil from water. There are negative ecological effects associated with such an extraction such as oil spills. There are several petroleum, oil, energy and gas companies all across the world that explore and drill oil.

Oil Trading

Let us discuss the Oil Trade from scratch. As to how exactly do oil change hands from producer to the consumer. On an average one barrel of oil is traded 27 times before it is delivered or consumed. It means every single barrel of oil in the form of paper exchanges at least 27 hands (bought and sold on paper) before it is consumed. Global oil consumption reached an all-time high of 87.4 million barrels per day in 2010. The volume of daily trade easily crosses 2 Billion transactions. In legal terms oil is traded on a regulated Exchange under Commodity Futures contracts.

Oil trading is no longer limited to oil producers and consumers; there are several parties involved in oil trading who function as one of the following heads.

oil-trading-process

 

  • Regulated Exchange: Exchange is also known as a ‘bourse’ is a regulated market place for buying-selling of equities, commodities, currencies through futures and option contracts. Some of the high volume commodity exchanges are CME group USA, Tokyo Commodity exchange Japan, NYSE Euronext USA, Dalian Commodity Exchange China and London Metal Exchange UK.
  • Clearing House: The role of a clearing house is to provide clearing and settlement services for transactions which are commodity based or financial in nature. Once the transaction is initiated, it is handed over to the Clearing house hence every Exchange has a Clearing house.
  • Hedgers (Market Participants – Buyer and seller or their brokers): Hedgers are usually the buyers or the sellers who are interested in passing or offsetting the price risk or potential loss to another party. Example: – Airline company, Manufacturing company, Petroleum or Energy based company. They usually appoint brokers who operate on their behalf for a fee.
  • Speculators:  Speculators are market experts who take the risk away from the hedger with an anticipation of making profits through market movement. Agents, Dealers, Brokers, Fund & Portfolio Managers and Banks usually act as speculators. Speculators play a very big role in oil price fluctuation and volatility. Traders (Speculators) buy, hold and sell what is commonly known as ‘Paper Oil’. Such an excessive paper based trading of oil brings in the price volatility.

Hedgers and Speculators are the real players of this game. Oil prices are highly volatile and always on rise.

There is an ongoing debate on nationalization of oil and eradicating speculation as these two measures are likely to bring stability in oil prices. Oil prices have spiked a whopping 340% in last 10 years from $26.18 to $94.05 per barrel. The world income has not multiplied at that rate. This has led to a steep rise in cost of living and reduction in disposable income.

Price per barrel (10 year trend)

oil-price-per-barrel-trend

 

The diagram below explains the process of Oil trading in its simplest form. Hedgers and Speculators enroll at an Exchange and buy Futures contract to either sell or buy oil. These contracts are available at a margin, which means a percentage of the contract needs to be deposited with the exchange. Contracts are marked to market every day with the closing prices. Associated profit and loss is adjusted from the account. If there is a loss, a Margin call is made. On the settlement date, the contract is closed through the Clearing house either by physical delivery at the stipulated location or cash. Positions can be closed anytime by taking off-setting or an opposite position.

Process of Oil Trading

The process of oil trading

 

Today oil is at the center of Geological, Political, and Social and Economic chaos in the world. Much is already written about the threats and dangers posed by excessive oil dependency for industrialization and there is a dire need to find alternative resources. World economy largely depends on the price of oil as oil prices are directly related to cost of living and inflation. Reserves are finite and depleting and the demand is increasing, this is leading the world to what is known as a ‘Peak Oil’ situation. Not only the Governments of the world but every human being consuming Oil and its products need to be thoroughly aware of this detrimental situation. ‘Conservation’ is the key.

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