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Oil Trading Basics

Oil can be traced back as far as biblical times, where far from being used for energy, it’s primary use was palliative and medicinal, along with more obvious uses as a pitch for boat building. It wasn’t until oil could be refined did it start to become a primary energy source, and this coupled with the extraction processes developed by Edwin Drake in Pennsylvania in the 1850’s led to it’s arrival on the world stage. However it was a very different world then to the one we live in today. When Edwin Drake constructed his first early oil derricks, the demand for oil was small, and oil trading did not exist! With low demand, the discovery of new oil reserves would send prices into freefall, and the whole industry was characterized by a boom and bust cycle with no oil trading exchange. Fortunes were made and lost in the early years and speculation was similar to that seen in the gold rush years of the Western frontier towns. What changed the oil trading industry forever, was the development of pipeline technology by the entrepreneur John D Rockefeller, who saw the opportunity to consolidate supply and manage the distribution more effectively. With long term investments in refining and pipelines, his Standard Oil Company became one of the largest oil trading companies in North America by the turn of the century. In 1901, Texas staked it’s claim on the world’s oil market with the Spindletop gusher and in 1917 The Railroad Commission of Texas became the regulatory authority for pipelines, followed two years later with the addition of the oil and gas industries to its jurisdiction. It is this organisation that later formed the working model for another regulatory authority, OPEC.

World War One established oil, and in particular petroleum, as the raw commodity, vital to military success. Around the world oil was being discovered elsewhere. BP oil trading, ( then called the Anglo Persian Oil Company) discovered oil in Iran in 1908 and in neighbouring Iraq similar discoveries were made in 1914 by the Iraq Petroleum company. Following the war, a rush of companies entering the market led to a glut of supply in the late 1920’s, followed by the Great depression of the 1930’s whilst at the same time more countries were striking oil such as Bahrain, Kuwait and Saudi Arabia, with the first shipments from Saudi, only leaving in 1946 due to the second World War. Following the war, from the 1950’s until the early 1970’s prices remained relatively stable at around $3 a barrel and in 1960 OPEC was formed with five founding members namely Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The first conference was held in Baghdad on September 10th 1960 and I propose to look in detail at OPEC and its influence ( both good and bad) shortly. What changed the face of world oil markets and the oil trading index forever was the Yom Kippur war and the Arab oil embargo.

At the start of 1972, crude oil was trading around $3 a barrel – two years later the price had risen to $12. Following the Syrian attack on Israel and Egypt on 5th October 1973, the US and many other Western countries showed support for Israel. As a direct result, the Arab exporting nations imposed an oil embargo on these countries. The net loss in production was approximately 4 million barrels per day and it is at this point that regulatory power over oil prices and the broader oil market in general was forever shifted from the United States to OPEC – in 6 months prices increased 400%. The next major event was the Iran/Iraq crisis of the late 1970’s and early 1980’s with production in Iran virtually coming to a halt and the loss of 2 million barrels a day from the market. The combined effects of the Iranian revolution and the war between the two countries caused oil prices to double from $14 a barrel in 1978 to $35 a barrel in 1992. The two countries have never returned to peak production since.

Following what became known as the Gulf War, crude oil prices entered a phase of steady decline which was only halted by changing strengths in the various world economies. The US was growing and the tiger economies of the Asia Pacific rim were booming, with a consequent decline in Russian production, but the sudden decline in the economic growth in the Far East and Asia, led to a sudden decline and over supply with prices falling again with the September 11th terrorist attack adding further to these falls.

With the invasion in Iraq, coupled with a loss of production in Venezuela due to a major strike in the oilfields, growing demand in Asia, and an improving US economy, demand increased dramatically with resulting increases in prices, a trend we have seen continue into today’s markets. Not least in recent times have been the contributory factors of a weak dollar and US refinery problems.

As you will appreciate the above is only a very brief look at the history of trading oil. It is a subject in itself – but I hope the above has given you a flavour of how complex this market is, and the amount of research and study you will have to put in, to become successful trading oil. There are many factors which will influence the market price, and I will cover as many of these as possible starting with OPEC – but what should start to become clear is that there are many factors you will have to think about, research, study and learn, in order to even start to take a view on future oil prices. This is a professional market with professional traders and one fraught with complexity and cannot be approached without an understanding of its dynamics and inner workings.