Crude Oil: What every investor needs to know

By Andy Hecht
Crude oil is considered by many to be the most important commodity market in the world. The value of crude oil affects almost every individual on the face of the earth in one way or another. Crude oil is the most liquid commodity market traded by virtue of the sheer volume that is transacted each and every day. Due to the volatility of this important market, there are always opportunities to make significant profits from both the long and the short side. One of the greatest crude oil traders in the world, Marc Rich, once said that oil is the blood that runs through the veins of the earth. His analogy is not only correct but important for all investors to include in their investment calculus. Crude oil prices affect everything that we do. As citizens of the world, we are all consumers of crude oil. We drive cars, heat our homes and purchase goods that are shipped to and from factories and to local stores and outlets. The trucks, barges, ships, planes and railcars that bring those products to market are often fueled by crude oil products. We use petroleum-based consumer goods every single day. Although we often do not think of it, crude oil is a fixture in our lives, much like our monthly rent or mortgage payment. The only problem is that the fuel costs are much more volatile than many of our other fixed expenses. We are all in the crude oil market in one way or another, and we all have some degree of crude oil knowledge. That is what makes crude oil an important investment vehicle. As a society, we are addicted to crude oil, and as investors we can use this knowledge and experience to enhance our investment portfolios. There are many ways to play this liquid and exciting market. Fortunes are made and lost every day. In addition to the crude oil market itself, investors can make returns in the refined products market. Refined products include gasoline, heating oil, diesel fuel, jet fuel and many other products that can be processed from the barrel of crude oil. These are also liquid markets that can offer investment opportunities. An informed investor can even take a view on the move of those oil products relative to the price of the oil itself! These moves often affect the price of the underlying crude oil. Oil is truly a global market. Oil trades at different prices in different locations. Understanding the differentials of crude oil prices in various locations around the world creates opportunities for investors to profit.

Crude Oil Stocks and Funds

If youre a conservative investor there are many equities and baskets of equities avail able that are highly correlated and sensitive to crude oil prices, refined product prices and refining spreads. Oil producers, explorers, refiners, drillers and equipment suppliers are all traded on global stock exchanges. All of these companies economic results take their direction from the price of crude oil. In fact, the price of crude oil and oil products directly affects the cost of goods sold of almost every business on earth. Therefore it is imperative for all investors to understand how this market works as well as keep up with developments and watch for price

movements that will certainly impact their nest eggs. Equity-based instruments such as energybased ETFs and ETNs also take their direction from the price of crude oil and crude oil products. These instruments are designed to allow investors to participate directly in the crude oil price movements that they purport to track. Keep in mind that there are so many instruments out there that are proxies for oil and oil products that you must do your homework to make sure that the product that you select fits both your portfolio and your risk profile.

Crude Oil Futures

Futures markets offer investors a leveraged way to participate in the daily moves of crude oil markets. The results of a position in the futures markets can be huge, and moves happen very fast. Its important to remember that futures offer high reward but a lso a high degree of risk. Futures are certainly not for the faint of heart. Futures in crude oil and crude oil products are only for the most advanced and sophisticated traders. They need to be monitored constantly as these markets trade and move 24 hours a day! With futures contracts traders can control huge quantities of crude oil on the long or short side for a fraction of the total value. This is achieved through the use of margin. However, owners of futures positions must settle market differences each and every day while maintaining initial margin levels as a good faith deposit for future price moves.

Crude Oil Options

There are certainly more aggressive ways to play this exciting market. Options are available on stocks, ETFs as well as futures contracts. Long options calls and puts on futures are limited risk instruments with limited time horizons that can provide huge returns for a small investment. Call options can be used to capture a quickly rising crude oil or oil product market while put options can be used to capture returns from a falling market. A combination of the two can be used to take advantage of high volatility even when you are not sure which way the market is going but you are sure that it is going to move big in one direction or the other! Short options offer a much higher level of risk but a seller of options can profit from periods of little or no volatility. No matter what vehicle you choose to participate in the international crude oil market, you will be happy that you did. You see, we all have basic knowledge of this important market after all, we are all consumers! You certainly monitor what is going on each time you fill up your gas tank. Once you start looking at crude oil as an investment vehicle it will focus you and hone your skills as a savvy trader. It will change the way you look at the world around you. When you turn on the evening news and hear a story about OPEC or the Middle East or U.S. Energy policy, you will begin to understand how macro and micro events worldwide affect your investment portfolio with respect to exposure in the oil markets. Every government around the world, whether they are a consuming or producing nation, pays a great deal of attention to the

international price of crude oil. Ben Bernanke, the Chairman of the U.S. Federal Reserve, never gives a speech or comments without referring to the international price of crude oil. Presidential debates and even debates for other offices in the U.S. and around the world often focus around energy policy. The bottom line is that the worlds spotlight is on crude oil. It already affects your investment portfolio, whether you know it or not. And, it always will!

Crude Oil Prices: What to watch

There are many factors that affect the price of crude oil and crude oil products. World events affect crude oil prices. The relative strength of the global economy and the economies of individual countries affect crude oil prices. For example, when an economy is growing rapidly, the demand for crude oil tends to increase as industrial production increases. The opposite is true when economies contract. Weather can affect the price of crude oil. Hurricane Katrina, in the Gulf of Mexico, was one of the reasons that crude oil prices spiked to $147 per barrel in 2008. Political stability or instability in oil producing nations will directly and quickly affect the price of crude oil. And, over the long run, demographics and population increases put strains on the finite supply of crude oil. Remember, this blood that flows through the veins of the earth is ultimately limited in supply. So here are four clues that I look at to give me a sense of future direction in terms of the price of crude oil and its products:

Clue #1: Fundamentals

Fundamentals is a fancy way of saying supply-and-demand analysis. Its Economics 101: If there is more supply than demand, prices tend to fall. If there is more demand than supply, prices tend to go up. It is as simple as that. There is always a lot of hoopla surrounding OPEC meetings. The question is always the same: Will the Organization of Petroleum Exporting Countries raise production or lower production? OPEC controls much of the physical flow of oil around the world. Members include some of the largest oil producing nations on earth such as Saudi Arabia, Iran, Nigeria and Venezuela. Their decisions can determine the future price of the commodity because it controls the supply available to consumers all over the world. At the end of each meeting, OPEC makes an announcement. Prior to the meeting, or while it is going on, analysts speculate on the answer to this question. If OPECs decision is in line with the analysts predictions, there is generally a muted response. If OPECs decision runs counter to expectations (as it often does), the crude oil and oil products markets tend to move violently. Theres an even simpler way to monitor fundamentals. Each week, both the U.S. Department of Energy and the American Petroleum Institute issue reports on the level of crude oil and oil

product stocks in the U.S. Prior to the release of these reports, consensus estimates of what stock levels will be are published on various news services for free. If the level of stocks is higher than estimates the crude oil and crude oil products markets tend to fall. If the level of stocks is lower than estimates they tend to go higher. Supply and demand numbers for this commodity can be invaluable information for a savvy trader looking to take advantage of short term moves in the market! While this method of trading does not work all of the time, it certainly works more often than not

Clue #2: Location, Location, Location!

Crude oil is produced on almost every corner of the earth. The benchmark internationally accepted crude oils for pricing purposes are WTI and Brent crude oil. Other grades of crude, such as sour crudes, trade in the international market and have higher sulfur contents. As a general rule, crude oil is considered "heavy" if it is high in wax content, or "light" if low in wax content: an API gravity of 34 or higher is "light", between 31-33 is "medium", and 30 or below is "heavy". Crude is considered "sweet" if it is low in sulfur content (< 0.5%/weight), or "sour" if high (> 1.0%/weight). Generally, the higher the API gravity (the "lighter" it is), the more valuable the crude. API gravity is the benchmark grading system for crude oil as proscribed by the American Petroleum Institute.

So the oil market has two key benchmark prices. Brent oil is the benchmark for Europe. Petroleum products and crude oil produced in the North Sea, Africa and the Middle East are generally priced relative to Brent oil prices. It turns out that the benchmark Brent oil price is used to price roughly two-thirds of the worlds internationally traded crude oil supplies! Brent crude oil is considered sweet crude. In the case of Brent, the sulfur content is approximately .37%. WTI Crude Oil is the other key benchmark price. West Texas Intermediate is the benchmark crude for North America. WTI crude is also sweet crude. In fact, it is sweeter than Brent oil as it has lower sulfur content (approximately .24%). It is called sweet because low sulfur crude has a mildly sweet taste, and it is generally the most sought after crude because it is the easiest and cheapest to refine into crude oil products such as gasoline. Generally, WTI is a better grade of crude oil for the production of gasoline and Brent oil favors the production of diesel fuel. WTI is traded on the NYMEX (New York Mercantile Exchange) division of the CME (Chicago Mercantile Exchange). This crude oil is generally for delivery in Cushing, Oklahoma. Asia uses both the Brent and WTI benchmarks to price their crude oil. There is an active market in the trading of WTI versus Brent crude oil. It costs about $3 - $4 per barrel to ship crude oil from Europe to the U.S. or from the U.S. to Europe but this can vary depending upon prevailing shipping rates.

There are also some differences in costs related to storage in these two oil trading hubs. In a normal market, the spread between these two locations hovers around $2.50 - $4.00, with the WTI crude trading at a premium to Brent, historically. Sometimes, due to world events and dislocations, the spread between these two low-sulfur crudes can move violently and for long periods of time. At the start of 2011, the Brent-WTI spread was around flat. The uprising in Egypt in February created fears that the Suez Canal might be closed, thus hampering the delivery of Middle Eastern crude oil to Europe. This caused Brent to move to a premium to WTI. At the same time a new pipeline, the Keystone pipeline, was opened, pumping Canadian oil sands to Cushing, Oklahoma. This put a strain on storage availability in Cushing, causing a temporary glut of crude oil at this delivery location. That caused the price of the spread between Brent crude and WTI to widen further. Then, political problems in Nigeria and planned maintenance on oil facilities in the North Sea made the spread go even wider. In late 2011, Brent crude oil actually traded at a premium of $30 over the WTI crude oil. More recently the spread has come lower with Brent trading at around an $8 premium to WTI at the time of writing this piece. Those are some amazing differentials, considering that WTI is historically the premium crude oil! Here is a weekly chart of the WTI-Brent crude oil spread:

When this spread started to widen in January 2011, the active month crude oil price was trading at around $80 per barrel. The dislocation and premium for the crude oil that is used to price roughly two-thirds of the worlds production (Brent) caused crude oil prices to rally from $80 per barrel to $114 per barrel in less than six months! Those prices are basis the NYMEX active month contract for WTI crude oil; the rally was even more significant basis the Brent crude! The point here is that drastic moves in prices of crude oil in one location can and will affect the price of the crude oil on a global basis. It is helpful to keep an eye on the Brent WTI spread!

Clue #3: Crack the code with refining spreads!

The process of refining crude oil into gasoline and heating oil (as well as other products such as diesel, jet fuel and even petroleum jelly) is referred to as crack spreads. A barrel of oil is cracked at a refinery into these oil products. The oil products are simply parts of the crude barrel. Refining is generally a very profitable business for oil companies. The wider the crack spread, the more money that the refinery makes. In other words, the higher the price for gasoline and heating oil relative to the price of crude oil, the more profits refining companies can generate from the refining process. Crack spreads are actively traded on the futures exchanges. There are times when crack spreads are actually more volatile than the underlying price of crude oil or products themselves! Lets take a look at an example: The RBOB gasoline crack spread traded on the NYMEX division of the CME:

As you can see, the average historical level for the gasoline crack spread is around $10-$15 per barrel. There have been instances when the crack has traded up to $40 per barrel (oil refiners make lots of money at this level) or down to a $15 discount per barrel (oil refiners lose lots of money at this level). The price of the crack spread for gasoline gives hints as to where the price of the underlying crude oil might be going.

Lets now take a look at the crack spread for heating oil traded on the NYMEX division of the CME:

As you can see, the historical average level for the heating oil crack spread on this monthly chart is around the $15 per barrel level. Heating oil is interesting because it also represents a close substitute for the value of diesel fuel. It is also often used as a hedge for diesel because heating oil and diesel fuel prices have similar properties and their prices tend to move in tandem. This spread has traded as high as $39 per barrel (again, refiners make lots of money at this level) and as low as $2.50 (where refiners do not do so well). As with the gasoline crack, the heating oil crack spread gives clues as to where the underlying price of crude oil might be headed. Gasoline and heating oil are seasonal products. Since the U.S. is the biggest consumer of oil in the world, gasoline tends to rally towards the summer months, or driving season. Heating oil tends to rally towards the winter months, or heating season. The diesel hedging angle always adds a small premium to the heating oil crack during off months, i.e. the summer or nonheating season!

So, lets put this all together

This chart shows the relationship between the crude oil price and the two crack spreads (heating oil and gasoline). There are often times when the crack spreads lead the crude or the crude leads the crack spreads. The bottom line here is that crack spreads, or refining spreads, can often give important signals as to the future direction of the underlying crude oil price movement! These spreads can also indicate future profit levels for companies that refine crude oil into oil products which can really give an investor a heads up in terms of investment opportunity.

Clue #4: Technical Indicators can be Very Useful

Technical indicators can be used as a guide map for what other influential traders and investors are doing in the market, any market. This is particularly true when it comes to crude oil prices. Often the herd buys or sells at the same time and this market volume will drive prices in one direction or another. Lets look at this daily chart of crude oil prices:

This daily chart of crude oil illustrates how important technical levels can be. Notice the period from February 18 through June 17 $95 per barrel acted as a key support level for the a ctive month crude oil contract. Once this level was broken, the $95 support became resistance. This gives an investor or trader a good idea of the range for the short term. Support and resistance levels are great guidance for where other market participants will be buyers or sellers! Also, notice that the market held the all-important 200-day moving average for a very long period of time. Once this level was broken on June 15, the crude oil market headed south and picked up steam! Technical indicators are often a great road map or blueprint for future prices.

Bringing This All Together

An investor or trader will gain a good feel for the potential price movements of the crude oil market using the four clues I describe in this report: Fundamentals, Location, Crack Spreads and Technical Analysis. I like to call this approach a technomental approach because it combines the fundamental aspects of market analysis with the technical aspects of market analysis. I often add volatility analysis using option prices and market ranges to the mix, but that, my friend, can be the subject of another offering in the future! As I pointed out in the very beginning of this report, we are all consumers in the crude oil market each and every day of our lives. Whether or not we realize it, we are all participants in this market, and our daily activities give each of us a pretty good feeling about the current

direction of crude oil prices. Whether you choose to take a conservative approach to the crude oil market by investing in oil-related equities or an aggressive approach using the options and futures markets, these tools will help you. Using your innate knowledge together with these tools can and will make you a better investor. They will help you identify compelling opportunities in the crude oil market the most liquid of all of the commodity markets.