A Simple Guide to Crude Oil Pricing

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As I have explained in a previous article, my focus from the 4th quarter of 2015 going forward I will spend my energies on crude oil. Previously, I traded currencies, EURUSD and GBPUSD in particular. While I achieved a lot of success in that, I decided to experiment something new to challenge myself. This came in form of crude oil; Brent in particular. I was interested in this commodity for a number of reasons. One, in crude, there are very data points compared to those relating to currencies. For instance, if you are trading EURUSD, you need to analyse data sources from Eurozone and those from the United States. Eurozone is made of many countries such as France, Germany and Italy. Therefore, it is important to have the knowledge on what is going on in all these countries. This is tough. On the other hand, when trading crude oil, you only need to understand a very few details. In fact, on a weekly basis, there are about 2 economic data relating to crude oil. In this article, I will explain a few issues about crude oil and how it’s priced. The chart below is a monthly chart for Brent from 1995.

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Demand and Supply

As with any commodity, the price of oil is determined by its demand and supply. When the supply is very high with the demand stagnant, then the price will move down. If on the other hand the demand is on the rise with the supply stagnant, then the price will definitely go high. Consider your local farmers market. In such a market, when there is a huge supply of tomatoes, shoppers usually have an option to buy from many farmers. Each farmer wants the buyer to buy from them. Therefore, in this situation, they will price the tomatoes at a lower price so that you can buy from them. This is the same way that the crude oil market works. On a weekly basis, EIA releases the crude oil inventory data. OPEC and other agencies also release this data on a regular basis. This data gives the market participants a good indication of what the oil market is like. As a trader, this data is very important. It should be on your fingertips. The demand for oil is caused by economic growth. As people and companies become more liquid, they tend to engage in more production. For instance, assume that you earn $1000 a month and therefore you opt to take a cab to work on a daily basis. Then, one day your boss calls you and gives you a pay hike. You will now be earning $6000 a month. This is an indication that the company is doing well. If you are not a fun of cabs, you will now opt to use your car leading to a slightly high demand for the product. The same is the case for countries and their economic growth. If a country reports improved economic numbers such as GDP, then it means that the people and companies will increase their spending on oil. This will lead to increased demand.

Geopolitical risks

The supply of oil is affected by a number of factors. For instance, if more countries discover huge oil deposits, oil will definitely increase in quantity. This increase in supply will lead to reduced prices. The largest oil producing countries include countries in the Middle East, China, USA and Russia among others. Sadly, these countries are faced with major geopolitical issues which affect how oil is supplied. For a trader, if news of political instability in the Middle East, you should always place a buy trade. This is simply because political instability could affect oil production thus curtain the amount of oil supply.