It’s not as shiny as gold, and doesn’t look as good on your girlfriend’s wrist, but oil is the most traded non-financial commodity in the world today. There’s no hanging around when this market decides to move, but this isn’t a market to cut your teeth on. The profit potential is huge but you need to be clued up before hitting the trade button. So grab a coffee and read on…

A Quick Geology Lesson
Let’s start with a brief geology lesson. Crude oil is the stuff that comes out of the ground. This is the basic, unprocessed product of dinosaurs and very old plants. This crude oil is then sent to finishing school, otherwise known as an oil refinery, where it gets distilled to produce a variety of products, ranging from petrol to heating gas to plastics. There is often talk of oil shortages, but this isn’t always true. For now there is still plenty of the thick, black stuff squirting out of the ground, but not enough capacity at the refineries to convert it into petrol or industrial fuel.

Peak Oil Theory
This won’t affect your day trading, but it’s worth just knowing a bit of the background. In a nutshell the theory goes that, as we run out of dead brontosauruses, there’s only a finite amount of oil on the planet. We don’t know how much is left, but every now and then people with beards and sandals make a prediction that we’re near or we’ve passed peak production. What is generally agreed though is that we’ve used up most of the easy-to-get oil. Which means what that the remaining reserves are less accessible reserves and so costlier to extract oil from.

Major Players
Of the 86 million barrels per day (bpd) produced, 39% comes from OPEC, 15% comes from countries of the former Soviet Union and the balance of 46% comes from non-OPEC sources like the US and Europe.

Organization of the Petroleum Exporting Countries (OPEC) is the international oil cartel, based in Vienna, whose aim is to try to balance supply and demand to get a fair (good) price for its members, but allow enough supply to prevent the industrialised world from seeking alternative sources of energy. Is it too cynical to suggest that, with oil reserves falling over the years, it’s in their interests to keep production tight and the price high? OPEC members meet twice a year to set output quotas, but can meet in response to acute moves in price or supply of oil.

Saudi Arabia has the role of swing producer (No, nothing to do with wild, camel swapping parties – it plays the role of smoothing production by cutting or increasing its own bpd to stabilize prices).

If you’re looking to trade oil then I suggest placing a diary note at least a week before any OPEC meeting as traders try to anticipate any quota announcements.

The Strategic Petroleum Reserve is the United States’ emergency oil stockpile, and it is the largest emergency petroleum supply in the world. The reserve stores about 570 million barrels of crude oil in underground salt caverns at four sites along the Gulf of Mexico. Any dipping into this reserve is going to be big news.

How To Trade Oil
There are two contracts available, Brent Crude and West Texas Intermediate (US Crude):

Brent Crude is the UK contract on oil sourced from the North Sea. And, hey! We might be crap at rugby, football, and cricket, but two thirds of the world’s internationally traded oil, from Europe, Africa and the Middle East, is priced relative to UK Brent Crude. So we Brits are the mutt’s nuts at … errr … something.

In the big boys’ market Brent Crude is traded in London as something called Futures contracts, which are priced in US Dollars. Now, all you traders brave enough to run your positions over a period of days or weeks, pay attention here:
Oil spread bets are monthly contracts. This means that:
a) You don’t pay any rollover charges; the bet will run until the contract ends;
b) You do need to put a note on your Kylie Minogue calendar that the spread bet runs out (expires) on a definite date.
c) Now, get this. The spread bet runs out (contract expires) in the middle of the month before the month it says on the tin. So, for example, the Brent Crude August contract on paddypowertrader runs out (expires) on 14th July. How dumb is that? It smacks of interference from a country that already writes the date back to front.
d) The expiry date varies month by month so the best thing is to click on the icon to the far right of the spread bet to bring up the information box. This will tell you exactly when your bet finishes.

West Texas Intermediate is the US equivalent to Brent Crude. Commonly known as US Light Sweet Crude (or any derivation of these words), it is called “US Crude” on the paddypowertradre platform. This one is traded in New York and again traded in monthly contracts, these run out towards the end of the month before the month on the tin so, as before, click the icon.

An alternative, less precise way of trading oil is through the equity market, but in my view this needs a good understanding of the underlying companies. For example, the rise in the oil price isn’t necessarily reflected in the major companies’ share price. This is partly because the cost and availability of refining impacts on the profit line and partly because, despite all the science, a large part of their business involves the costly process of sticking long poles in the ground and seeing if they come up black.

There are exceptions; smaller companies like Tullow Oil and Dana Petroleum are linked more to exploration than refining. Each new discovery seems to notch up a couple of quid on the share price. And they’ve got the added attraction that one of the majors might decide it’s cheaper to bid for them than to look for new reserves itself.

Effect On The FTSE
The Oil & Gas sector accounts for roughly 20% of the FTSE, so whatever happens to the oil majors will have quite an effect on the underlying market.

What To Watch When Trading
Trading oil involves keeping an eye on a few different factors to the standard investment stuff. In addition to the run of the mill economic data that will gives clues as to whether the world’s factories are burning more or less oil there’re a couple of seasonal factors:

First, courtesy of Top Gear, there’s the US Driving Season - (apparently the land of the gas-guzzler has a particular season for driving, starting on Memorial Day at the end of May and finishing on Labour Day at the start of September).

Now switch over to the weather forecast to see how windy it is. The US Hurricane Season officially runs from 1st June to 30th November, but don’t expect the forces of nature to pay too much attention to the dates. An average season has 11 named storms with six growing into hurricanes, but only two reaching major hurricane status. So don’t go buying oil every time your weathercock spins round. Official thumbs in the air for 2010 predict 8-14 hurricanes, which would be a near record for storm activity. So why is the hurricane season so significant to the oil market in particular? Hurricanes tend to hit the Gulf of Mexico, which is filled to the rafters with oilrigs (over 20 rigs went missing due to Hurricane Katrina in 2005).

Notice the seasonal rise in the oil price during the hurricane season.

On a smaller, less destructive scale watch out for particularly cold winters where the heating’s turned on full blast and, paradoxically, particularly hot summers in the US, where they prefer turning on the ‘aircon’ to sitting in the shade.

Next take a look at the world’s big oil producers. You won’t find oil gushing out of stable and predicatble countries like Belgium, Sweden or Switzerland. No, putting aside the comparatively stable USA and Saudi Arabia, God blessed the world’s more colourful characters with the power and wealth of massive oil supplies. A short roll call includes Iraq, Iran, Libya, Nigeria, Venezuela and Russia, where a few well-chosen words from a president can send you sprinting to the ‘trade’ button.

And finally the most specific economic data to focus on are the US weekly oil and gas inventory figures, issued by the Energy Information Administration and released every week on Wednesday afternoons. If you trade oil you can’t afford to miss these. Clink on the link to read Brian’s excellent piece on Trading The Oil Inventory Number.

Oil Trading Strategies
The choice here is between trading your views and using technical analysis. If you’re trading a view bear in mind you’ll be up against specialists who might have the inside track on something. I feel that my views don’t give me an edge so I prefer to use TA. I’ve found that the oil market doesn’t respect all aspects of TA so prefer to keep things simple, mostly using the following:

Support & Resistance
Moving Averages

But if you’re new to charting there’re plenty more tricks to try out on the Educational Articles page.

Some Useful Websites
US Energy Information Administration
International Energy Agency
BP Strategy Page
Hurricane Watch

Conclusion
So now you should have a few ideas on how to trade oil, who and what are important and the sort of things that drive the oil price. But I’ll finish with a word of warning for Newbies; the volatility that makes this market such fun to trade can strip your account like a school of piranhas. Do your trading capital a big, big favour and use the demo account for a while whilst you learn the tricks of the market. Then edge in gently with small bet sizes. There’s no rush; there’ll still be an oil market to trade when you’re ready.