Understanding The Oil Market

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It can safely be said that the world runs on oil. From the gasoline that powers our cars and trucks to the many oil byproducts that often fuel power generators, and even petroleum-based plastics, oil is just about everywhere you look. That’s why it can be a lucrative trading opportunity for graduates from the Online Master of Science in Finance degree program from Northeastern University’s D’Amore-McKim School of Business, but the oil market is not very similar to the stocks and bonds most are familiar with.

Oil fundamentals

According to the U.S. Energy Information Administration, crude oil has been and should continue to be the leading source of energy around the world. This fact is expected to remain true through at least 2040, by which time global energy consumption of all types is projected to increase by 48 percent over 2012 levels.

With demand for oil not expected to vanish anytime soon, one might expect it to be relatively expensive and price-stable. However in recent years, this has proven to be a misconception. As of Aug. 1, a barrel of crude oil (equal to 42 gallons) cost $52 on the international market. Since the start of 2015, this price has remained relatively the same, but it has seen extreme fluctuations in almost every year since 2008. In the summer of that year, oil prices skyrocketed to well over $100 per barrel. Prices ebbed between $75 and $100 between 2011 and 2014 as well.

In securities like common stock certificates, this level of instability would be a cause for concern. However, in the oil market and most other commodities, it is generally accepted as normal, at least in recent years. There are so many factors that go into the price of oil, making its price susceptible to changes in the global economic or political landscape. For example, recently announced sanctions imposed on Venezuela, a major oil exporter and nation in the midst of mass political turmoil, are only the latest development that could serve to shift prices.

Political concerns

Another interesting wrinkle in the oil world is the fact that much of the world’s supply is controlled by relatively few. The Organization for Petroleum Exporting Countries (OPEC) is a conglomerate of nations that accounts for around 40 percent of the world’s oil output. Lead by Saudi Arabia, which boasts the most oil reserves of any nation, OPEC has historically exerted a strong influence on prices. But that control has waned as other nations, particularly the U.S., have found new ways to extract oil from their relatively meager supplies.

The current consensus on the future of oil prices is that they will probably remain near their current level, and almost certainly not return to their 2008 peak for several years. Reporting its quarterly earnings results, Royal Dutch Shell CEO Ben van Beurden remarked that the international oil company was operating under the assumption that prices would stay “lower forever.” Major oil producers like Shell suffered big losses ever since the product’s price downturn around 2014, and have only recently begun turning a profit again.

How to invest in oil

Since the cardinal rule of investing generally favors those who “buy low, sell high,” the current price environment of oil seems to indicate now might be a good time to buy in. But novice investors should tread carefully when first entering the oil market.

The first thing to know about trading oil is that it is done using futures contracts. This is an agreement to buy or sell a product at a future date, usually a few months in advance, at an agreed price. Oil and many other commodities are traded as futures because there is a lot of time between when oil is drilled out of the ground and when it can be transported and sold in a usable form.

Futures allow traders to lock in a price, but they involve some additional risk. For example, if the price of oil were to rise between its purchase date and its delivery date, the holder of that contract might then sell to another party for additional profit. Since futures are a very liquid asset and can gain value quickly, brokers of futures tend to allow more customers to rack up debt from purchasing them. Some brokerage firms or exchanges might allow for leverage ratios of 10 to one or even higher, meaning a 5 percent change (positive or negative) in the price of oil would inflict a gain or loss of 50 percent.

As with the entire world of finance, the high risk of futures trading can invite even higher reward. But investors have to be especially careful if they are looking to make bets on the oil market. Trading futures with less debt can help investors hedge against other risks, rather than gamble through speculation.

In the end, investing in the oil market through futures contracts, or simply buying common stock in major oil companies, could be a part of a diversified investment strategy. Be sure to weigh all the benefits and risks of any investment plan through careful research, or only do so on the advice of an experienced, trusted financial professional.

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