Nicole WillingThe historic negative turn in WTI crude oil prices in 2020 has attracted the attention of investors looking to profit from trading on the volatility in the market.
If you are considering investing in the oil market for the first time you might have some questions about how it works: What are crude oil futures? Why do investors start trading oil futures? How are oil prices explained? What are the pros and cons of investing in oil futures? How can you trade oil futures contracts?
Here we define WTI and Brent oil futures trading and cover the basics of the markets to get you started. Moreover, we have also included our Oil Futures Explained video, in which David Jones, chief market strategist at Capital.com, explains the different types of oil contracts and summarises what drives the market.
Crude oil futures explained: what are oil futures?
There are a few different options for crude oil futures investing. There are two major oil markets worldwide: Brent Crude, which is extracted from the North Sea and serves as the global benchmark, and West Texas Intermediate (WTI), which is primarily extracted from oil fields in Texas, Louisiana and North Dakota and forms the US benchmark.
Brent Crude is a high-quality light, sweet oil blend, which describes its low density and low sulphur content. Brent accounts for around two-thirds of global oil pricing, making it a clear option for investors new to the market.
Oil produced in Europe, the Middle East and Africa is priced at differentials to Brent based on specifications. Middle Eastern crudes tend to be heavier sour blends with higher sulphur content than Brent. Meanwhile, WTI crude is lighter and sweeter than Brent.
Brent Oil futures have established a widening premium to WTI futures in recent years, as the North Sea oil fields have become depleted while North American production from shale formations and oil sands has expanded rapidly.
As well as trading crude oil futures, investors can opt to trade spot contracts for Brent or WTI, which represent the cash price for immediate delivery of one barrel of oil, to capture short-term movements in the markets with trades of a few hours or a few days.
Crude oil futures trading is done on exchanges – the New York Mercantile Exchange (NYMEX) for WTI and the Intercontinental Exchange (ICE) for Brent. Futures are used by investors looking to hold trades for longer periods than spot contracts. Futures contracts are derivatives that give the holder the right to buy the commodity at a specified price on the settlement date. Standard futures contracts on exchanges represent the price for 1,000 barrels of oil for delivery in a specific month, with a premium for timescales further out to cover the cost of storage and financing. Contracts are typically available for each month in the next few years.
The benchmark month ahead, known as the front month, is the most liquid contract as that is where trading activity is focused. Oil traders include financial institutions such as banks, trading firms and hedge funds as well as oil producers and consumers. Like financial institutions, individual investors never take physical delivery of the oil they trade, instead rolling over their monthly contracts to the following month on expiry to keep their positions open.
Watch crude oil futures explained in this video with our chief market strategist David Jones, as he details the main features of the market and what you need to know about the contracts available for trading through CFDs at the Capital.com platform.
What determines crude oil prices
Crude oil prices are driven by demand (indicated by the strength of the global economy and in particular manufacturing output and transportation) as well as supply from producers in key oil-producing regions including North America, the Middle East, and Russia.
Geopolitical developments have a strong impact on prices, as seen in 2020 with a price war between Saudi Arabia and Russia driving prices down. The amount of oil storage capacity available can also determine the commodity’s value: full storage points to oversupply, while low levels of oil in storage indicate tight supply.
The combination of the price war, demand destruction during the Covid-19 pandemic and limited storage availability prompted the negative turn in prices in spring 2020. Extreme weather events can also affect the oil market if production is disrupted, as when Hurricane Katrina hit US output in 2005, driving prices to record highs.
Over the longer term, the International Energy Agency expects oil demand to peak in the late 2020s as international environmental policies favour carbon emissions reduction through energy efficiency and the electrification of transport.
Why trade crude oil futures?
There are several reasons for an individual investor to consider trading oil future contracts. The rapid rebound from negative WTI prices proved to be lucrative for traders that were prepared to take on the risk, indicating why investors might opt to add crude oil futures to their portfolios.
As one of the world’s most traded commodities, crude oil offers a level of liquidity that allows investors to open and close positions with ease. Its massive price volatility allows traders to make large profits, often in short periods of time, as it is highly responsive to its key drivers. Oil contracts offer a solid portfolio diversification of asset classes beyond stocks, bonds and other instruments. And as a physical market, the dynamics of crude oil pricing are more straightforward for some investors to understand than other financial assets that may seem less transparent.
But there are also reasons to be cautious. The short-term nature of the cash and monthly oil futures contracts, which decay as they reach expiry, requires investors to actively manage their positions. So, if you decide to start trading crude oil futures, you will need to make sure you monitor your positions and the current market drivers regularly. It is important to develop an understanding of global macroeconomic data trends and how they affect the oil market. Whether or not you decide to invest will depend on your risk tolerance.
The main difference between CFD trading and trading assets, such as commodities and stocks, is that you don’t own the underlying asset when you trade on a CFD.
You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional trading you enter a contract to exchange the legal ownership of the individual shares or the commodities for money, and you own this until you sell it again.
CFDs are leveraged products, which means that you only need to deposit a percentage of the full value of the CFD trade in order to open a position. But with traditional trading, you buy the assets for the full amount. In the UK, there is no stamp duty on CFD trading, but there is when you buy stocks, for example.
CFDs attract overnight costs to hold the trades (unless you use 1-1 leverage), which makes them more suited to short-term trading opportunities. Stocks and commodities are more normally bought and held for longer. You might also pay a broker commission or fees when buying and selling assets direct and you’d need somewhere to store them safely.
