So when we talk of oil, what exactly do we mean?
Crude oil is formed when the remains of plants and animals are covered in sand and other organic matter, and over millions of years the pressure causes them to turn into sedimentary rock and eventually oil.
Due to the fact that the oil is formed deep underground (either on land or under the sea), the extraction process involves digging deep into oil reserves, through layers of rock, and it is therefore very costly to extract and produce.
This cost of extraction is consequently factored into oil market prices, with an increased cost of production inevitably leading to an increase in oil prices.
Even more significant than the cost of extraction is the fact that there is only a limited availability of oil available anywhere in the world. Oil is found in only a handful of countries, the most significant of which are the 12 OPEC countries (Organization of Petroleum Exporting Countries), and together these 12 countries account for over 75% of all proven oil reserves in the world.
The most significant OPEC members include Saudi Arabia, Iran, the United Arab Emirates, Kuwait, Venezuela and Nigeria.
As a trader we therefore need to constantly monitor levels of production, exportation levels, and any disruption that may occur in major oil exporting countries. Any increase or decrease in production will impact prices.
When calculating oil prices a huge consideration is the fact that oil is a finite resource which will one day run out. As supplies dwindle, or become harder to extract, prices will increase. The long term price trend for oil is therefore very much predictable.
Types of Oil Traded
When we talk of trading oil, the oils we generally mean are WTI, which is short for West Texas Intermediate oil (also known as Crude Oil) and Brent Crude Oil, often referred to as Brent.
WTI is produced in the USA and Brent is produced in the North Sea. Both are high quality oils, and this means that once they have been extracted from the ground they can be refined to make it usable for lots of different purposes.
Uses include refining into petrol to power a car, as fuel in the generation of electricity and heating, and also to create plastics, petrochemicals and many other products. This therefore means that both WTI and Brent are constantly in very high demand around the world, and are consequently highly correlated.