Module 8 Currency & Commodity Futures

Chapter 10

Crude Oil (Part 1), digging the past

83

m8-c10-cartoon

10.1 – The Commodities super star

If I have to pick one international commodity which can give you all the dramatic ups and downs of stock markets as portrayed in the movies, then it has to be the ‘Crude Oil’. Wonder why? Have a look at the chart below –

image-1_10-year-crude-oil

The dramatic rise to $140 per barrel to the immediate sharp correction, then a recovery back to near $110 to a merciless crash to sub $30, the crude oil chart can invoke all human emotions, just like a perfectly well directed movie! The fact that this is an international commodity, actively traded by hundreds of thousands of traders across the globe only adds to the complexity of it all.

So what is really going on in crude? Why did crude crack from the highs of $115 all the way down to $28? What caused this manic panic? What is happening to crude now? Where are we headed now? To understand this fully, we need to rewind and dig into the recent history of 2014 – 15.

This is exactly what we will do in this chapter. For the sake of this chapter, let us go back to first half of 2015 and see how things looked back then.

10.2 – The crisis revisited

From over $110 per barrel in January 2014 to a low of $28 per barrel in January 2016, the Brent Crude oil has perhaps seen the worst decline in prices over the recent 5 years. While this dramatic price decline has brought cheer to a few corporate and perhaps few countries, it has disrupted oil producing economies. Literally nobody saw this coming; even if someone did, the magnitude of this fall (over 75%) was beyond everybody’s wildest imagination. Is this the bottom of the crash? Well, your guess is as good as mine, but the intensity of the crash in crude oil is so severe, it would be hard to believe the bottom is in sight.

So what really went wrong?

To understand what went wrong, we need to understand the dynamics of crude oil and how business was carried out before the recent crash. This discussion also doubles up as ‘oil basics’ for you. Oil rich countries produced several million barrels of crude oil which were exported to The US, China, India, and European countries on a daily basis. The oil producing countries are split into two baskets –

  1. “Organization of the Petroleum Exporting Countries (OPEC)” nations which include countries like Saudi Arabia, Qatar, Kuwait, UAE, etc., and
  2. Other oil producing countries such as – Brazil, Canada, Russia, Mexico, Norway, etc., choose not be part of the oil cartel i.e. OPEC. Hence they are just referred to as ‘Non OPEC countries”.

Between the OPEC and non OPEC countries, close to 90 million barrels of oil were pumped on a daily basis. The graph below shows the daily oil production split between OPEC and non OPEC countries –

image-2_production-data

The Trigger

Different countries produce oil at different rates; this rate at which they produce mainly depends on the individual country’s finances and technology. While production depends on internal factors, the sale of oil has always been driven by markets. Clearly the breakeven point (expressed on a per barrel basis), is the rate at which countries need to sell per barrel of oil to cover the expense of producing the same, varies from country to country. Naturally, selling oil below the breakeven point implies that the country cannot balance their state budget. The table below shows the breakeven points for the OPEC countries –

Country Breakeven point on a per barrel basis*
Iran $130.7
Algeria $130.5
Nigeria $122.5
Venezuela $117.5
Saudi Arabia $106.0
Iraq $100.6
UAE $77.3
Qatar $60.0
Kuwait $54.0

In the backdrop of these trade dynamics, a triple digit oil price till early 2013 worked really well for the oil producing economies. However the recent developments changed the landscape of crude oil business dynamics. Specifically, the following three major events turned the tables around for crude oil prices –

  1. American Shale Oil – The American shale oil, which comes from oil shale (sedimentary rocks containing bituminous material), which is an alternate to crude oil became technologically viable and the cost of producing the same became relatively cheaper. The output from the American Shale oil production increased, flooding the market with cheaper oil. By current estimates, it is believed that US has enough shale oil reserves to last generations. Shale oil from Texas and North Dakota displaced exports from OPEC members to The USA. This set the stage for a collapse in crude oil prices.
  2. Lack of co-ordinate action – In the backdrop of increased shale oil production in The USA and the ongoing slide in crude oil price, one of the methods for oil producing countries to control the situation was to lower the supplies and regulate the demand supply situation. However, OPEC was not really successful in convincing OPEC and other non OPEC oil producing countries to cut the crude oil production to support the crude price. In fact cutting oil production is considered more expensive than pumping oil.
  3. China Factor – China has been one of the largest consumers of major international commodities including iron ore, coal, and crude oil. In fact in 2013 China surpassed The US in oil imports. However reports suggest that the Chinese economy is not growing at the same pace as it used to, resulting in lower demand for international commodities. Needless to say, this has a significant impact on the spiraling crude oil prices.
  4. Market Dynamics – The above three points triggered a steep sell off in crude oil, adding fire to this sell off was the heavy short positions built up on Crude Oil contracts.

Generally when the price of crude oil falls, the US dollar tends to get stronger especially over the currencies of the emerging economies. This is quite natural as an increase in oil price widens the US current account deficit (remember US also imports oil from the Middle East), which obviously is not a great factor for the US Dollar, and the reverse helps the dollar strengthen. Hence the Dollar and oil share an inverse relation. Do recollect, in 2008 when Oil hit a peak of $148, US Dollar was trading at 1.6 to the EURO.

The Russian Episode

Russia is one of the largest (non OPEC) producers and exporters of oil. The Russian federation’s oil exports contribute nearly 40% of the total exports. With a slump in oil prices, the Russian economy seems considerably weakened. There are three factors working against Russia, two of which can be directly attributed to the oil prices –

  1. Oil Price – Russia needs the oil prices to be approximately in the region of $105 – $107 to balance its budget and keep its finances in order; clearly with oil at $50, Russia gets a severe blow on its budget.
  2. Ruble Trouble – Remember, Russia is an emerging economy. With the slide in oil price, the Russian Ruble has massively weakened against the US Dollar. So much so, that the Russian Central Bank increased the interest rate overnight by 7.5% in order to defend the Ruble (yes, this did happen back in 2015).
  3. Crimea Curse – Western countries continue to impose sanction cuts on Russia for its aggression on Ukraine. This means access to external capital is extremely difficult (especially when it’s most required) for Russia.

Add to this the Syrian crisis, and a host of other local factors, there is little hope that that Russia may not actually slip into a financial coma dragging the federation into a recession.

The India macro angle

On the face of it, the fall in crude oil seems to significantly benefit India as the pressure on petroleum subsidy eases. India being a net oil importer (nearly two-third of India’s oil is imported) pays a heavy bill for its oil imports. Naturally the fall in crude oil means improvement in the fiscal deficit, easing of inflation and possibility of an interest rate cut.  All of which is desirable for India in the backdrop of the current economic situation.

But there is another angle to low oil prices. While low oil prices help the domestic import bill, it will also impact our exports receipts. Most of the exports from India are to countries whose economy depends on oil – UAE, US, Saudi Arabia, Kuwait, Iran, China etc. Quite naturally, with low oil prices the spending by these countries also decreases, thereby impacting business with India.

In fact, if you go back and look at the October 2014 import & export data from RBI, it clearly suggests the same – while the oil import bill reduced by 19% (y-o-y), the exports also declined by 5%. Clearly the advantage of low oil price is not the boon it seems to be. In fact, on 6th January 2015 we got a glimpse into what can happen if the oil price continues its fall – the NSE Nifty fell over 255 (~ 3.0% decline) points creating a ruckus on the street.

Impact on the Indian Companies

State owned oil marketing companies (OMC) such as HPCL, BPCL, and IOC are a direct beneficiary of low oil prices. Low oil price has a positive impact on oil marketing companies (OMC) in terms of reducing the stress on their working capital requirements. In fact, both BPCL and HPCL have retired over 50% and 30% of their short term borrowings over the last two years respectively. If the price of crude oil prices stabilizes around the current level of $50 per barrel, then naturally it will be great for these companies in term of cleaning up their balance sheets and improving their bottom line.

Is this the end?

Well, this just depends on the supply-demand situation. Clearly as Saudi Prince Al-Waleed Bin Talal says, “If the supply stays where it is and the demand continues to be where it is, then there is little hope for the oil prices to bottom out here”. Besides, the US has withdrawn the 40 year ban on export of oil– which means more supply to the market, thereby putting more pressure on prices.

Last month, i.e., September 2016, OPEC has finally agreed to cut the production in order to support the oil price. You can read the article on Bloomberg.

American shale oil has no doubt created a ripple in the market but there is another angle to this – how strong are the balance sheet of these companies fracking shale oil? Are they over leveraged? Are they overstating the reserves?  These are things the market will learn sooner or later; which will again impact crude oil prices.

However at this stage if you ask me – is this the bottom of the oil price crash? Well, your guess is as good as mine.

Please note, unlike all the previous chapters on Varsity, this chapter will not have any key take away points as I’ve just narrated what really happened to crude. What we have discussed today could just be a piece of irrelevant history going forward!

PS: I have taken all the inputs for this chapter form The special report on oil crisis was published by Dalal Street Investment journal, authored by me. 

 

 

83 comments

  1. KSA says:

    Thank you very much for this chapter sir.. And also thanks for not delayed this chapter.

  2. Dileep says:

    in kite, it applies same settings of first chart to all subsequent charts. is that normal?

  3. Khyati verdhan says:

    Sir I very much like this chapter
    This chapter give me knowledge about fundamental of crude oil
    I hope the next chapter has its technical part

    • Karthik Rangappa says:

      Glad you liked it. We will discussing the contract details in the next chapter, which hopefully should be out next week.

  4. vivekdubey says:

    Dear Karthik,
    You and your team is doing remarkable job, I have read all the modules its very simple and easy to understands, I have request I am very much concern about the Risk Management, Reward Risk .
    I am making the excel file for reducing the risk in day trading. For making the perfect file i will be required to understands the risk management – Can You please help me out to solve my problem.

    Thanks

    Vivek Dubey

    • Karthik Rangappa says:

      Thanks Vivek. I’m happy you liked the content.

      In fact we are planning on developing a module on Risk management soon.

  5. CHAITANYA KALE says:

    Wishes u and yr family very happy Dipawali.

  6. CHANDRASEKHAR KARA says:

    WISHING TEAM ZERODHA A HAPPY & PROSPEROUS DIWALI

  7. Kaushik says:

    Hi.
    Can you pls share some idea about other commodity loke zinc nickel copper , aluminium etc

    Wht are the factors that influence price of these commodities and what us the best strategy to trade them ?

    • Karthik Rangappa says:

      Of course we will, this module is work in progress. We will eventually add chapters on all the commodities.

    • saurabhrendale says:

      +1 There Kaushik, I am also interested in trading commodities, however, don’t have enough knowledge. All works good on paper, however, when I enter a trade, it’s a mess :(.

      Thank you, Karthik .

      • Karthik Rangappa says:

        Just to add my 2 cents – most of the good things initially starts in a mess, idea is to keep going 🙂

        • saurabhrendale says:

          Hi Karthik,

          Thank you for your two cents, I’ll always keep that in mind.

          I am highly impressed with you, Nithin and all the team members at Zerodha, the way you all are striving to help people and would like to thank each one of you and specially you with the efforts of sharing and making all the knowledge available to us at Varsity….please keep up with the good work that you guys are doing.

          Thank you so much…. 🙂

          • Karthik Rangappa says:

            Thank you so much for the kind words. Good luck and happy trading.

          • saurabhrendale says:

            Hi Karthik,

            Just one more request, I read the stories of winners and consistent performers at the Zerodha connect page, I felt that there are only people who are trading in futures and options, stock market and nifty who have given their success stories, however, I want to know whether there are people who are trading in commodity market also. I would like to request you to add their stories as well.

            Thank you,

          • Karthik Rangappa says:

            Good idea, will give this a shot.

          • saurabhrendale says:

            Thank you again, Karthik.

          • Karthik Rangappa says:

            Welcome!

  8. Ambati malleswararao says:

    Excellent job thank you for zerodha

  9. Dhiraj says:

    From the above comments i read heading in futures. i found that you mention hedging with options also in the options module, but could not find it in the options module..
    ” However you can hedge such positions by employing options. We will discuss the same when we take up options.”
    ——————- This mentioned in the Future hedging chapter

    Can you please let me know , where is the location for hedging with options on this varsity, please.

  10. uday says:

    Hi Karthik,
    this query is not related to above topic.
    how can we get NSE live stock prices in Excel. is there any way.
    thanks in advance

  11. Chandrasekhar says:

    Sir when wil this chapter come & when will the risk management module come? Will it be completed by jan 2017? Please reply

    • Karthik Rangappa says:

      I understand the delay is quite a bit. This is because of various other activities that’s happening. I’m guessing I’ll be able to pick up pace in couple of weeks from now. Thank you for your patience.

  12. Khyati verdhan says:

    Hi kartik
    Why many COMMODITY like platinum, pladinum are not traded in mcx. If I want to trade them what should I do

    • Karthik Rangappa says:

      Platinum futures are available over the international exchanges…but not yet in India. I guess introduction of commodities on MCX is a function of the real world application of the commodity in our day to day lives…platinum from what I know has very small real world application…maybe at the most 1/10th….and paladium is highly sensitive, given its application in nuclear warfare.

      Anyway, this just my guess work, if I get an opportunity to speak to someone from MCX, I’ll find out what they think about this as well.

  13. PK says:

    Sir, simply great work by Zerodha team by sharing mammoth amount of knowledge and that too in simple words.
    I would like to point out problems with Kite. On the day of Brexit/US election results, the slow performance is understandable e.g logging in. But not on days like today, 15 Nov. Kindly ask your tech team to work on it to utilise it better. Many thanks.

  14. yashkmd says:

    Hi Kartik,
    Can you please explain the correlation between the US dollar and the crude prices in detail. I didn’t get it. 🙂

  15. Ameya says:

    Hi Karthik,
    From commodities perspective, suppose I buy 1 lot of aluminium with a margin of around Rs. 33k and if I go into loss suddenly by 1 or 1.5 point. Will my position get automatically squared off? In general, What percentage of margin reduction from the prescribed one will cause the position to get automatically squared off ?

    • Karthik Rangappa says:

      The position will be squared off if the loss exceeds the SPAN requirement and you do not have sufficient funds in the account.

  16. Prashanth says:

    Hi Karthik,
    Can we use technical analysis for commodity . Where can I find underlying commodity graphs (Spot price graphs).?
    PS: Good learning from you. You have created a invaluable resource for simple and effective knowledge. Felt like reading 100 books :).

    • Karthik Rangappa says:

      Thanks for the kind words Prashant!

      Yes, TA can be applied to commodities. In fact, it can be applied to any asset which has time series data. The futures charts are available on Kite/Pi. I’m not too sure about where to find the spot price charts.

  17. SHYAM SHANKAR DHAR says:

    How underlying price of a comodity is determined?who decides it?how it changes second by second?

    • Karthik Rangappa says:

      The regular demand supply for the underlying commodity dictates the price of the commodity in the spot market. For example, the price of an agri commodity like cotton is dictated by the farmers and buyers at the mandi.

  18. Ram says:

    Hi, how to buy crude oil in lot? when i try to order it takes for only one quantity, it is not showing in lots.

  19. g_kab35 says:

    Hi Karthik.. Thanks for providing knowledge & insights.
    I m a businessman & part time commodity trader. My nature of work does not allow me to be in touch with market during working hours. So 4 Hrs or EOD TF suits me best. Can u please suggest me some good strategy to positional trade in Crude Oil? Thanks in advance.

  20. Ashok says:

    So, i have few questions regarding commodity positional trading…
    Do I need to square off 5 days before expiry to avoid physical delivery?
    What happens if i don’t square off?
    What to do if i find a trading opportunity before 2 days of expiry? Should i ignore that?

    • Karthik Rangappa says:

      It depends on the commodity. Some 5 days and some are 4 days. If you dont then, it implies that you have expressed interest in participating in physical delivery…so additional burden of warehouse receipts etc.If you find and trading opportunity 2 days before, then its best to implement it in the next months contract.

      • Ashok says:

        Thank you. I read somewhere that my position will auto square off in Zerodha before 5 days to avoid physical delivery? It this true?

  21. anyket says:

    Hello Sir,
    I have opened a commodity account with zerodha. I am not able to fund it as I am abroad and I get no cellphone network and hence I am not able to receive OTP. Hence I am not able to carry out any online transaction. Can you please tell me of a way to fund the account. Can i transfer some funds from my equity to commodity account?

  22. Hi Karthik, I can’t thank you enough for the work you have done here on Varsity. This is tremendous and incredible treasure for any learner. I have a question – might be very basic though – can you tell me how you see the open price of a stock or future at the start of the day? For example, if you see crude oil mini future for August 21 expiry, the 1 Day candle shows the open & low price as 3088 for 26th Jul 2017 but when you change that to 15 minutes candle the price did not come below 3091. Also, the first candle’s open price is 3126. It’ll be of great help if you can clear this.

    • I’m using Kite to see these values and chart – just an FYI.

    • Karthik Rangappa says:

      Thanks for the kind words, I’m happy you liked the content we have put up here.

      This happens because of the following reasons –

      1) It is very normal for a contract like Curde Mini to get volatile at open
      2) A volatile scrip like this can attract 1000’s of ticks per second
      3) It would be impossible to capture all these ticks – hence the chances of missing ticks at open is very high
      4) At the end of the day, we sync the OHLC data with the data provided by exchange’s ‘Bhav copy’ – so the EOD charts are always more reliable

      So yes, I’d prefer to see the EOD data….however, if you are doing intraday there are not many options.

  23. Pratik says:

    Hello Karthik,

    What is the underlying spot price to monitor for trading Crude Oil on MCX? Is that Brent Crude Spot (UKOIL) or WTI Crude (USOIL)?

    Also, what is the difference between UKOIL and BCOSD pair? I saw different scrips on TradingView but trading at same price!

    Regards,
    Pratik

  24. Manas says:

    Hey Karthik,

    CME is open 23 hrs, MCX only 14,
    Is investing.com chart data reliable for 23 hr crude charts? (for Wave analysis)
    If not can you suggest any other charting websites please?

    Thanks 🙂

  25. Rishab Khandelwal says:

    Hi Karthik,

    Thanks a lot for sharing your immense knowledge with us.

    I think a small correction is required in this chapter.

    OPEC stands for The Organization of the Petroleum Exporting Countries, not “Organization of the Petroleum Countries”.

    Thanks.

  26. Mahesh Krishna says:

    I am trying very hard to get continuous profit in crude oil … but couldn’t ……

  27. Arun says:

    Dear karthik ,
    ” In fact cutting oil production is considered more expensive than pumping oil” as quoted in this chapter.
    why is it so??

  28. MURARI MALDHURE says:

    Dear Sir, I have Zerodha A/c of equity. In equity A/c the fund is near about 15000/-. Now I want to trade in commodities. Please guide me how can I add or transfer my amount for trading into commodity. I had tried to put an order of Crud Oil M 18 July Future but the order had been rejected. Please guide me.

    • Karthik Rangappa says:

      Looks like your commodities account is not open, Murari. Can you touch base with our support desk? Thanks.

  29. Shivasharan says:

    Can we trade more than 100 lots in crude ?
    if yes, then what is the limit ? and any rules/ conditions ?

  30. Ayush says:

    Dear sir, please add bracket order option in commodity also.

  31. Naimey Kaplish says:

    Hello Sir,

    Sir I need to know where I can look for Crude Oil 1 Min Chart since inception. 1 Day and every other time frame is available. It will be a great help for me sir. Hope to get a positive response soon sir.
    Regards.

Post a comment