Energy products are varied and have many end uses. Crude oil, for example, can be used to make gasoline or as a raw material in the manufacturing of plastics. Natural gas can be used for heating applications as well as a feedstock for plastics, chemicals and other applications.
Since energy products can be refined products like gasoline, which is directly consumed, or raw inputs like crude oil, which can be made in to other products, the fundamental trader will need to consider the factors that influence supply and demand for the raw material, as well as supply and demand for any secondary products. Traders who trade crude oil will look at all the sources of demand both foreign and domestic not just the demand for gasoline.
Supply and Demand
Energy products, specifically, are very sensitive to changes in supply and demand. Small changes in either can have a noticeable effect on the price of the energy futures contract. Traders will pay attention to data releases concerning the supply and demand of the energy products they are interested in. For example, a crude oil trader will watch the weekly inventory reports to remain updated on the current build or drawdown details of crude oil and build a case of where they believe the price of crude oil will move next.
Another example is if crude oil inventories increase the price of crude 2% one week and decrease it by the same amount the next week, traders will make sure they are aware of the potential for large moves in the price of the futures contract and trade accordingly to limit their risk.
The main drivers of the price of energy products are user demand, inventory build and drawdown cycles (the supply cycle), and seasonality.
Demand is increased by economic growth along with consumer and industrial demand. If the economy is growing, then energy demands will be higher from both consumers and industry.
Some of the factors that create increased demand when economies are growing are: increased demand from automobiles and trucks, increased power consumption requiring increased energy demands, more heat requirements for homes and buildings and more requirements for energy products that are used as inputs in manufacturing.
Supply, or inventory build, also has many factors that make energy unique when compared to other commodities.
Build and Drawdown
Energy futures go through what is referred to as a build and drawdown cycle. Most energy products are extracted from the ground then transported to storage facilities, where they are stored to be delivered to the ultimate users. This is the build phase.
The drawdown phase is when the product is shipped from the storage facility to the end user. If production is lower than what is needed to satisfy current demand then there will be a drawdown in inventories, and if production is higher than the quantity which is being demanded then inventories will increase.
Traders will be familiar with this data in relation to the crude oil report which comes out every week and tells traders whether there has been a build or drawdown in crude oil reserves.
If energy supplies are higher or demand is lower, then price should decrease. If supplies are lower or demand is higher, then price should increase. Energy products follow the basic rules for supply and demand just like any commodity.
Seasonality also plays a part in the supply and demand for energy products. There are times during the year when, due to weather, demand might be higher or lower than normal. This might be due to increased demand for heating during winter months or increased demand during the summer months where vehicle use is typically higher.
Seasonality effects on energy futures are generally predictable as they occur during the same time each year, but what is not predictable is the actual demand during the season.
For example, natural gas goes through a seasonal build to ensure there is enough supply to meet the typically higher demand for heating during the winter generated by lower temperatures. Like most things in the market, price moves based on a combination of actual data and the assumptions that the market makes for price in the future.
Natural gas suppliers will make projections for demand over the coming winter. They will purchase the quantity of gas they believe will be required. If the winter is warmer or colder than anticipated, then actual demand will be different than forecasted demand. It is this difference that will affect the price of the futures contract. If demand is higher than anticipated by the market then price will go up, if it is lower than price will go down.
Traders who trade energy futures are aware that there are unique factors that will influence the price of the futures contract they are trading and use fundamental analysis to help them analyze the market and make their trading decisions.
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Peter Knight Advisor