Commodity Futures: Energy

Updated: Sep 21, 2020

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Speculators and investors are becoming increasingly attracted to the multiple functions of energy futures contracts. Energy products have many end users which are varied. Crude oil can be used to make various refined products, like gasoline, diesel, jet fuel / kerosene, propane, naphtha / petrochemical feedstock and fuel oil products. Natural gas can be used for heating, cooling and electric power generation as well as a feedstock for plastics and chemicals. Traders will need to consider the various factors that drive both foreign and domestic supply and demand for raw material, as well as supply and demand for the refined or processed products.

Energy products are specifically very sensitive to changes in supply and demand. Small changes can have significant effects on energy futures contracts prices. Traders look to data releases concerning the supply and demand of the energy products they. For e.g. a crude oil trader will watch weekly inventory reports from Energy Information Administration (EIA) and American Petroleum Institute (API) to remain updated on the current build or drawdown of crude oil in order to build a case of where they believe the price of crude oil will move next. The main drivers of price of energy products are user demand, inventory build and drawdown cycles (supply cycle), and seasonality.

Economic growth along with consumer and industrial demands will result in demand for crude oil. When the economy is growing, energy demand increase for consumer and industrial sectors. Some factors could be higher demand from transportation sector; such as cars and lorries; added industrial demand for power consumption; higher heating and cooling demand for homes and buildings; and more needs for energy products that are used in manufacturing; such as polymers, plastics and construction materials.

Supply of energy products has many factors that makes it unique when compared to other commodities: energy products go through what is referred to as a build and drawdown cycle. The inventory build phase is when energy raw materials, such are crude oil and natural gas, are extracted from the ground, then transported to storage facilities. Refined petroleum products are produced in refineries and other processing plants, stored in bulk facility before being delivered to the ultimate users. The inventory drawdown phase is when the product is shipped from the bulk storage facility to the end user. If supply is lower than what is needed to satisfy current demand, there will be a decrease in inventories, and if supply is higher than the quantity demanded then inventories will increase.

The EIA and API weekly reports provide information on crude oil stocks, production, refinery utilization, imports/exports, and demand with detailed breakdown by product and region.

Certain political events, such as military conflict or oil embargos can trigger massive short term knee-jerk fluctuations in price of crude oil, in terms of perceived drop in crude oil supply. Announcements from OPEC (Organization of Petroleum Exporting Countries), an oil cartel (oligopoly) stating if they agree to increase or reduce crude oil supply, would be scrutinized to predict how the oil prices will move.

Energy products follow the basic rules for supply and demand: If energy supplies are higher or demand is lower, then prices should drop. If supplies are lower or demand is higher, then prices should rise. In addition, a significant oversupply of oil coupled with a drastic reduction in global demand can intensify the downward pressure on oil prices. During times where there is great uncertainty and volatility, there are substantial price moves. In extreme circumstances, the price of oil can go into negative territory: in April 2020 when supply and storage utilization were high while demand was low, resulting in a negative price for oil.

Traders typically use both technical and fundamental analysis for supply and demand in crude oil. Technical analysis may believe that there is strong resistance at $100 per barrel of oil, because every time price has reached that resistance level it is followed by a price decrease. Price cannot move past $100 because buyers cannot create enough demand to buy at that price and above to move sellers out of the way. Fundamental analysis may know that different oil producers have different cost and realizes that at around $100 per barrel, there is a trigger for many oil producers to turn on wells with higher production costs that were not operating when the cost was lower, increasing supply and decreasing price. Crude oil has a range of extraction costs, some wells might be cost effective below $40 and others might not be cost effective until prices reaches $60 or higher. This is because oil is extracted from different sources (e.g. deep under-sea wells and shale oils) have vastly different exploration and extraction costs.

Seasonality plays a part in the supply and demand for energy products: there are certain times during the year when demand might be higher or lower than normal due to weather. This might be due to more demand for heating fuels during winter months, or more demand for transportation fuels during summer months when vehicle use is typically higher. Seasonality effects on energy futures are somewhat predictable as they occur during the same time each year, but the actual demand changes during the season is not predictable. Price fluctuations are based on combination of actual data and assumptions that market makes for future prices.

For e.g., natural gas goes through a seasonal build to ensure there is enough supply to meet the typically higher demand for heating during the winter due to freezing temperatures. Natural gas suppliers will make projections for demand over the coming winter and will purchase the quantity of gas they believe will be required. If the winter is warmer or colder than anticipated, then actual demand will be different than forecasted. This difference can impact the future contract price. If demand is higher than anticipated by market then price will rise, if it is lower, then price will drop.

In conclusion, traders of energy futures must be aware of the complex unique factors that drive the price of energy futures contracts, then use demand and supply analysis to evaluate market conditions for decision-making.

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