Oil trading 101

For those of us who never studied finance or economics, terms such as hedging, futures and long position are very mysterious.  Let’s look at a basic oil trading strategy: selling the futures spread, to understand some of these terms.[i]

First of all, what is a futures contract?

If I sell a contract, to deliver 1000 barrels of oil in December 2015, I have  sold an oil futures contract.

For example, I promise to supply a customer, let’s call him Harry Potter, with 1000 barrels of oil in December. Harry pays this December price to secure his supply and I lock in a comfortable price. Why would Harry do that? If the December futures price is currently $50 Harry probably believes that, come December, the real oil price will have changed. If it turns out to really be $70 (multiplied by 1000 barrels!) then Harry has won. He paid his supplier – me – much less then he would have paid if he had waited until December.

$70 – the actual price of oil in December – is called the December “spot” price.

On the other hand, if it turns out the December spot price falls to $45 then the supplier made the better deal. I wait until December to buy 1000 barrels of oil at $45 each. I supply these barrels to grumpy Harry who already paid me $5 more per barrel and rather thought he had made a good deal back in March.

Oil future prices emerge because different players have different expectations about how oil prices will evolve.

Current market conditions

The oil futures market  is currently in deep contango. What does this mean? Contango means traders expect the price of a barrel of oil to be higher in the future than it is today. Deep contango means this price will be a lot higher. Yet, as we just saw above, when delivery day arrives the spot market might tell another story.

As a trader I need to make a prediction about what will happen over the next few months

For example:

  • Oil storage facilities are near capacity in Europe and essentially full in the US. Storage is becoming inaccessible.
  • Today’s spot prices are at a historic low. I might think they are likely to drop further, since producers cannot store oil to sell later and will be forced to dump their supplies somewhere.
  • Many producers are becoming unprofitable. Investment in new oil production projects is being put on hold because prices around $40-$50/barrel are not enough to cover production costs.
  • If there are few new projects to replace current production then oil supplies will eventually tighten and prices will increase. But not for at least a year or two. Identifying this lag is crucial.

This means the contango will deepen.

Based on the above predictions, I would expect the futures spread to widen. That is, the difference between the spot and future price of oil will get much bigger.[ii] Why?

To reiterate: spot prices will decrease as we have a situation of oversupply that is likely worsen when oil storage facilities run out. Then the oil futures price will increase, relative to spot, since the market is not expected to tighten for one or two years. This pattern should hold for some months.

My trading strategy, based on these expectations, is to sell the futures spread.[iii]

Selling the futures spread means I sell a futures contract for a near month  and buy a futures contract a far month. This will be profitable if I am right about the contango spread increasing.

For example:

It is March 2015.


  • Sell April oil futures contract @ $48.13
  • Buy May oil futures contract @ $49.13
  • The spread is -$1 per contract.

It is now April 2015 and I need to offset my position.


  • Buy April WTI spot contract @ $47.13
  • Sell May WTI futures contract @ $51.13
  • The spread is now -$4 per contract.

Intuitively -4.00 < -1.00

So I sold something at a higher price than I bought it back for. Profit!

My total profit is: (-1) – (-4) = $3 x 1000 contracts = $3000

A helpful guideline:

Which trading strategy to use?   Contango time spread (normal market) Backwardated time spread  (inverted market)
Expect the spread to widen Sell spread Buy spread
Expect the spread to narrow Buy spread Sell spread

Selling the spread:  short the near futures position and long the far futures position.

Buying the spread: long the near futures position and short the far futures position.

[i] Please be aware that this example is pure fiction and the author takes no responsibility for losses or gains made by anyone trading oil futures based on the above-described strategy.

[ii] It does not really matter what the price level is per se. So it’s not helpful to say “prices will go up.” Relative to what?

[iii] Short = sell, long = buy. These terms do not have anything to do with time-frames!


Oil prices not too low for Saudi Arabia

My last post explained why international oil prices have fallen dramatically during the last six months. This has harmed the profitability of many oil producers.

International oil traders and producing companies have called on the Organisation of Petroleum Exporting Countries (OPEC) to react to the fall in oil prices. Saudi Arabia is the biggest producing country within OPEC and often represents the group. But what can the Saudis do?

For a long time Saudi Arabia was the world’s largest oil producer. The shale oil revolution changed this. Last year, we saw the US overtake both Saudi Arabia and Russia – the other big player – to become the world’s largest oil producer. Nevertheless, the US consumes a lot of what it produces. Saudi Arabia is still the world’s biggest exporter. Moreover, its vast reserves and production capacity allow it to “swing” supplies. That is, quickly alter the volume of oil it puts into the international market. In a nutshell, decreasing copious OPEC supplies would alleviate the international supply-glut and boost the international oil price.

To do this OPEC must accept a decrease in total sales volumes and a smaller market share. The burden of cutting back volumes falls predominantly on Saudi Arabia as OPEC’s biggest producer. Saudi Arabia has had experience in the past with cutting supplies whilst other OPEC members “free ride.” Meaning they benefit from an increase in prices without decreasing their sales volumes as agreed.[1]

International producers are effectively asking Saudi Arabia to do them the same favour. Just why would it do so in a competitive market?

For the moment Saudi Arabia has indeed refused to offer anyone any favours. What’s more getting oil out of the ground is very cheap in Saudi Arabia. Its oil wells have some of the lowest “lifting” or production costs in the world. This is what the graph below shows us:

BEP - IEA graph

The ultra-polluting Canadian tar sands projects are well out-of-the-money at oil prices of $50/barrel, since it costs $85 to produce a barrel of oil.[2]

The graph also shows us that Saudi Arabia can remain profitable close to $20/barrel. It could let current prices keep falling without sacrificing market share. Today’s oil price is less of a problem for Saudi Arabia than other countries where lifting costs are higher.

Yet, it is unlikely Saudi Arabia will let prices fall that far. Profits from oil sales directly support the Saudi government’s budget. Also, higher prices eventually become more important than sales volumes as profit margins tighten. For example, if I sell ten barrels at $100 each this is the same as selling a hundred at $10 each. Except that if it cost me $9 to produce each barrel my total profit is $910 in the first scenario and only $100 in the second scenario.

For now Saudi Arabia appears content to keep the price low and wait for US shale oil producers with thinning profit margins to leave the market. This strategy will cause the US shale oil revolution to lose pace and protect Saudi Arabia’s market share in the long term. However, we might see OPEC revise their policy later in 2015.

[1] It’s hard to measure exact output and countries report their own production volumes.

[2] I’ll write about the economic feasibility of the tar sands projects soon.

Why is oil suddenly so cheap?

Between 1998 and 2008 the price of oil increased ten-fold. Everyone was talking about peak oil – the idea that production would plateau and demand for oil would outstrip supply. Skyrocketing prices would force us to replace what we put in our cars. In 2008 prices broke the $100/barrel ceiling – and then kept climbing.

What does it mean to say oil is $100 per barrel? When we talk about dollars we mean American dollars. Barrels are just a standard measure of volume (159 litres). The price of oil refers to a benchmark – a reference price. In the United States this is West Texas Intermediate (WTI), which is a blend of crude oils from diverse suppliers, which mingle at a physical hub in Cushing, Oklahoma. In Europe the benchmark is called Brent – a blend of North Sea produced crude oils. For a crude to become a benchmark there must be enough suppliers and enough barrels that the supply, and therefore the price, cannot be controlled by one player.

Crude oil needs to be processed and refined to produce the more valuable products, such as gasoline or jet fuel, that industry and consumers can actually use. So it is refineries that buy crude oil from producers. However refiners don’t all buy WTI. There are many different varieties of crude oil. An oil producer will mark up or mark down their crude oil relative to a reference price. This is why we call WTI and Brent benchmarks.

What determines this mark up or mark down? The quality of your oil. Oil can be light or heavy – a lighter, less viscous crude produces more of the more valuable petroleum products such as gasoline during the refining process. Oils are also classified as sweet or sour, which refers to the sulphur content. Sulphur is a pollutant which must be removed during refining. This is expensive to do. So the more sour your oil the more pricey the sulphur-removal process.

Oil producers are in the game to turn a profit.The WTI price affects your profitability as a producer.  For example, let’s say WTI is $100/barrel. If it costs you $70/barrel to extract crude oil from a well and you are selling it at a $20 discount to WTI then your profit per barrel is $10/barrel. (That’s a huge win.)

However, if the international price of oil – the WTI benchmark – falls $10 then you lose your profit margin.

A few years after WTI hit $100/barrel (and then went higher) it suddenly fell to $50. Multiply that by the millions of barrels being bought and sold and you can imagine there were some pretty big winners and losers. That’s the situation we have today. But why?

In less than one hundred and fifty words:

1. Since 2008 Europe underwent a recession which dampened demand for oil as economic growth dwindled and consumer spending dropped.

2. The United States is the world’s biggest oil consumer and used to drive global demand. However, over the past few years an energy revolution no one predicted took place in the US. As shale gas “frackers” began producing natural gas and pumping it into the regional pipeline networks, associated shale oil was also being produced. The best fields are called “wet” since they produce oil as well as gas, oil being more valuable. So within a few years the US went from being a huge importer to near self-sufficiency in crude oil production.

3. This meant that global oil markets were dramatically over-supplied. The supply glut happened because two of the biggest markets – Europe and the US – simply weren’t as hungry for crude oil anymore.

These days we actually talk about peak demand for oil. Technology and extraction processes get better every year, so it’s likely we will be able to produce oil for many years to come. However, production will become more expensive and, as environmental pressures weigh in, oil will become pricey enough that consumers and governments look for replacements. Even if that means buying an electric car or investing heavily in public transport.

Peak demand didn’t happen when prices skyrocketed in 2008. It might yet. Or it’s possible that demand for oil is dropping away. The international price will wane if other energy sources or energy efficiency measures become more competitive and attractive. We will have to wait and see if oil demand recovers in Europe or if Asia’s growth fills the gap.