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Understanding oil as a commodity

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Understanding oil as a commodity

October 02, 2018

Since its discovery, oil changed the course of history for the entire humankind. It so happens that over one hundred years after the first oil discovery, the societies we live in are strongly dependent on the oil and oil market prices.

A single barrel of oil is responsible for a multitude of products, starting with gasoline to power a standard car, kerosene for jets, and even enough derivatives to use in the petrochemical industry. We travel faster, longer distances and more efficient, because of oil.

Oil, hence, is a source of power. Wars have been fought because of it, and people and nations go to extreme lengths to own oil reserves, to discover new ones, and so on.

Like any commodity, oil comes in limited supplies. Understanding the role of oil in the financial markets, society and trading is crucial for understanding how money moves and how the balance of power in the world depends on this curious commodity.

Oil as a Balance of Power

Before oil, the Middle East countries had little or no riches. Suddenly, with the discovery of vast oil reserves in the region, the big oil companies from the United States, the Netherlands or the United Kingdom, started to invest massively in the region.

Tempting the rulers with royalties that stretched for tens of years, companies brought the Middle-East oil to the market to offset oil from regions like Baku, North Sea, and all-important Texas, United States.

Countries throughout the Middle-East saw the potential and enjoyed an enormous benefit ever since. Today’s examples of how United Arab Emirates, Kuwait, Saudi Arabia, developed, are relevant to the importance of oil and how the money flow changed the Middle-East scenery.

At the same time, oil put Middle-East on the world’s map. Just like that, countries with little or no saying in international affairs found themselves in a position to influence the world’s important decisions.

Kissinger and the Saudis

Before asking what does has to do with trading financial markets, let’s review what is the pillar of today’s financial system as we know it. That is the U.S. Dollar.

Have you ever thought why oil is sold only in USD? Why not in Euros, Pounds, or Australian Dollars, for a change?

History tells us that after the Bretton Woods conference, the United States promised to exchange every dollar in the world with gold, at a fixed rate. This made the dollar as good as gold and increased the trust in the American monetary policy.

However, 1971 saw President Nixon giving that up. The impossibility to fund the deficits forced the United States to drop the agreement. Just like that, countries around the world found themselves with dollars, but no gold to redeem for the banknotes. It was all a game of trust.

In a smart move, Nixon sent Kissinger to Saudi Arabia to reach a deal that has consequences even to our days. The so-called “petrodollar” was born when Kissinger got Saudi Arabia to promise it will sell all its oil only in USD.

Moreover, the excess from the oil revenues was to be invested in U.S. Treasuries. Simply put, the excess bought U.S. debt.

What was in for Saudi Arabia? Military protection in the area, among riches from the oil royalties.

The trick worked, and to this day the USD remained the world’s reserve currency. The Kissinger deal brought trust back to the USD, and the Nixon “shock” was quickly forgotten.

The Petrodollar was responsible for most of the economic growth in the decades that followed, showing the importance of oil as a commodity in today’s financial system.

Other countries followed the same path, and, with little exceptions, the USD is still used as the one and only currency to pay for oil transactions.

Types of Oil in the Market

Oil differs depending on the sulfur percentages it contains. The more sulfur, the more expensive to refine it into usable products.

There are various types of oil, but only one price for it. The most relevant types are WTI (West Texas Intermediate) oil, Brent and OPEC oil.

WTI is the finest crude oil that exists, with the lowest sulfur percentage. It comes from the United States, while Brent comes from a multitude of oil wells in the North Sea.

The OPEC (Organization of Petroleum Exporting Countries) unites producing countries with the idea to control production levels and prices. Led by Saudi Arabia as the leading producing country, OPEC countries “give” a different crude than WTI and Brent.

Most of the times there is a premium between WTI, Brent and OPEC oils, and it could be that brokers offer one single product or all of them to trade. As a financial instrument, it comes in the form of a CFD (Contract for Difference) and follows the same rules as any leveraged product. Traders can take both long and short positions.

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Oil and Inflation

Oil is key to today’s central banking. Everything surrounding us depends on oil. Hence our actions depend on the price of oil.

For instance, when the price of oil increases dramatically, transportation costs shoot higher. This translates in retailers increasing the consumer prices to cover for the higher transportation costs.

Hence, inflation rises. When inflation rises, central banks hike the interest rates.

When central banks raise rates, the currency appreciates. This is how oil is the critical element for today’s monetary policy.

Conclusion

Many think of oil as just a simple commodity, but it is much more than that. The price of oil has the power to influence monetary policies around the world because most of them have a mandate that revolves around inflation.

Because of oil’s direct relation with inflation, central banks consider oil prices before changing the monetary policy.

The perfect example came from a few years ago when the oil price dropped from over $100 to the $30 level.

oil1year1.jpg

The drop created a shock in the financial markets, as many central banks were forced to ease the monetary policies due to inflation fell well below the target. In some cases, even below the zero level.



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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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