Six Important Points You Should Know about Energy Trading

The Types of Energy Products

So, what is energy trading? Energy products are one of three types of commodities, the others being soft commodities (agricultural products) and hard commodities (metals).

Energy products are any commodities used to create energy in its various forms – i.e. electricity, heat, gasoline, and diesel. The main energy commodity is crude oil, which is used to create fuel, electricity, and synthetic materials. Natural gas and other energy related products like gasoline and propane are also traded. Renewable energy trading products also exist, but these markets are less developed and more difficult to trade.

Besides these different energy related products, traders can choose from various instruments. These include physical commodities, futures contracts, CFDs (contracts for difference), ETFs, and other derivatives like options. In addition, some traders choose to trade the shares of energy companies like BP, Exxon and Shell.

Brent vs WTI Crude Oil

Oil from various parts of the world are differ slightly and are better suited to producing different products. While there are several different types of oil that are traded, Brent crude and West Texas Intermediate (WTI) are the most widely traded.

WTI crude comes from Oklahoma in the US. It has a low sulphur content making it easier to process and is quite light. It used to trade at a premium as it was favoured by buyers. Recently it has lost its position as the global benchmark due to competition from other sources of oil in North America. 

Brent crude comes from the North Sea in the Atlantic and is the benchmark in Europe. Because it doesn’t have as much competition as WTI from other sources, it is now becoming the global crude benchmark.

The Fundamentals That Affect Supply

Like any market, the price of energy is determined by supply and demand. The price of oil, gas and other energy products moves towards a level where supply and demand are balanced.

Oil supply depends on the number of oil rigs in operation, how much is being produced and the size of known oil reserves. If new reserves are found, supply can increase, and the price will fall. OPEC can influence the supply of oil by increasing or decreasing their production targets. Geo political events can also affect the supply chain, causing prices to rise.

The Fundamentals That Affect Demand

Demand is primarily affected by global economic activity and growth. As economies grow, more oil is needed, and if the increased demand isn’t matched by new supply, prices will rise.

The weather can also affect demand for natural gas and heating oil. Colder winters lead to more demand, while mild winters reduce demand. Finally, demand is also affected by the availability of substitutes in the form of wind and solar power. So far, renewable energy has had a very small effect on oil demand, but in time it’s expected to grow.

Understand the concept of Contango

Contango and backwardation are concepts that can occur in all futures markets but are very common in energy markets. If there is more demand for futures contracts than there is in the spot market, the futures price will trade above the spot price (the price of the physical asset). This is known as contango.

However, at expiry, the futures price and the spot price have to converge. This means with contango, futures prices can fall sharply as the expiry date approaches. In addition, if traders want to roll over their positions from the current contract to a later expiry, they may have to sell the current contract at a loss, and then buy the next expiry date at a premium. The opposite from contango is backwardation, however this isn’t as much of a problem as the price moves higher before expiry, and traders get to buy the next contract at a discount.

Contango is common in the energy futures market because it’s much easier to trade energy futures than physical oil or gas. Whether you are trading energy futures or CFDs based on the spot price, contango is something to be aware of as it can create volatility and opportunity, as well as increased risk.

Decide Which Time Frame You Are Trading

Energy markets can experience persistent trends, sometimes lasting years. However, in the short-term, prices can also experience sharp corrections, and consolidate in tight ranges.

A common mistake traders make is entering a trade with a long-term time horizon, and then exiting based on short term price action. A similar mistake is using fundamental analysis for entries and price action for exits.

Long term trades need room to play out, as do positions based on the long-term fundamental outlook. If you are trading for the long term, you will need to give trades room to work and ignore intraday volatility. There is nothing wrong with trading energy markets on shorter time frames, but this should be kept separate from any long-term trades.

You Can Trade CFDs On the Spot Price or On the Futures Price

The One Financial Markets online energy trading platform offers CFDs on spot and futures prices. You can trade the spot price of natural gas, Brent crude and West Texas crude, and you can also trade WTI crude oil futures.

Even if you don’t trade them all, it’s well worth following all of these markets. Energy markets are heavily influenced by futures markets and following the different markets will give you a much better feel for the market.

Energy markets are also highly connected. Different products can be substituted for one another, which means anything happening in one market will have a knock-on effect in other markets. In fact, knowing what’s happening in each market will often alert you to opportunities in other markets.

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