HardAssetsInvestor

Energy Markets

It doesn't take a genius to say that energy - and more specifically, oil - is hot. With prices topping $90/barrel and $3.00/gallon at the pump, the energy market has become the defining sector of commodities.

What drives the energy markets? And how can you, as an investor, understand it ... and maybe profit from it?

You've come to the right place. Just sit back, relax, and we'll take you through the basics of the energy markets.

 

Crude Oil

Crude oil drives the energy markets. It influences the wealth of nations and the health of the global economy.

So what is oil? The snide answer is "Oil is what's left of prehistoric plants and animals after time and pressure have gotten a hold of them." That's geophysically correct, but it does nothing to help you understand what oil is today.

"Crude Oil" isn't as simple as it sounds. There are variations in grades of oils ranging from extra light to heavy, as well as sweet (read: clean) and sour (read: full of sulfur). The "heaviness" of the oil refers to its relative weight or viscosity. The best oil - the crème de la crème - is light and sweet. Light, sweet crude takes the least effort to refine. Heavy oil is more difficult to extract as well as refine, and sour oil requires further refinement to remove the extra sulfur.

Because oil comes in different grades, it isn't universally priced - it is in a very real way much less of a classic commodity than gold, because it varies in location and quality. In the financial markets, oil is also classified by where it is available.

When you hear about oil on the news, chances are that people are talking about West Texas Intermediate (WTI) crude oil. WTI is a light sweet crude that is extracted in North America and delivered to Cushing, Oklahoma. (Why is it called "West Texas Intermediate" instead of "Oklahoma Crude"? Somehow, Oklahoma just doesn't have that ring to it.) WTI contracts are traded on the New York Mercantile Exchange (NYMEX), and are among the most liquid financial contracts in the world.

The other popular grade of oil in the financial markets is Brent Crude. Brent crude comes from the North Sea and is commonly traded in Europe. Brent crude is also light and sweet, though neither as light nor as sweet as WTI. Typically, WTI trades about a dollar or two higher than Brent, because WTI is better oil; that's not always the case, however.

Beyond the big two there is an alphabet soup of other grades: Dubai, Tapis, Minas and even the OPEC Basket, which is a weighted average of oil from OPEC countries.

 

Where It Comes From

The five biggest oil producers are Saudi Arabia, Russia, the United States, Iran and China. Saudi Arabia holds about a fifth of the world's proven oil reserves (260 billion barrels), with most of it being light and sweet. Saudi Arabia exports almost half of its production to Asia and about 20% of its production to the US. Russia, the second largest oil producer (with 60 billion barrels of proven oil reserves) exports 70% of its production, with most going to Central and Eastern Europe, though some does make its way to the U.S. The United States itself is producing less and importing more oil each year (hence the perpetual debates about drilling for more in the Arctic). Iran is the fourth largest oil producer in the world and holds about 10% of the world's proven oil reserves (136 billion barrels); it is also the second largest OPEC producer. China, sitting on 18.3 billion barrels of proven oil reserves, rounds out the top five oil producers, but like the U.S., is a net oil importer, a situation which is only going to get worse.

 

OPEC

The big axe in the oil business isn't just Saudi Arabia, however: it's OPEC. As a cartel, OPEC lives to violate the kinds of anti-monopoly laws designed to keep markets in the U.S. free and open.

OPEC's goal is to manipulate the available supply of oil to keep prices at the "optimum" point: the one where OPEC members make the maximum amount of profit from their natural oil supplies. There are a dozen nations in the OPEC cartel.

Whether OPEC is actually effective at its stated goal is a topic for debate, but the simple fact is that when OPEC sneezes, the oil market catches a cold. The cartel holds regular meetings where the member countries agree to at least try and stick to certain quotas. When they say "let's pump more!" prices tend to come down. When they cut production ... well, you get the idea.

 

Peak Oil

No matter how much oil OPEC pumps, however, one truism about the oil markets is that there's only so much of the stuff to go around. Eventually, we'll use it all up; they aren't making dinosaurs like they used to these days...

When we'll use it up, however, is a critical question, and one which has fostered the "peak oil" debate. Peak oil advocated believer that we either have already or will soon reach the point where it becomes economically impossible to get any additional oil production out of the ground. This has necessary doomsday-like implications, and, again, is a topic all its own.

 

Profits Up, Exploration Up

Regardless of whether we've hit the tipping point of peak oil, recent high prices have changed the game in the oil business. When prices rise, the oil business gets more profitable. And when that happens, oil companies and entrepreneurs can spend more money accessing new supply. Historically, mankind has grabbed oil where it was easiest to get and easiest to use: light sweet crude from the shallowest locations. But there's oil in other places too: deep in the ocean, or trapped in sand or buried shale. In the past, oil shale and resources like the Canadian tar sands haven't been worth investigating. But with oil at $90 a barrel, that equation is changing.

This is good news in places like Canada which has huge oil sand fields that are now viable. And the U.S. is sitting on the largest deposit of shale oil in the world - a moderate estimate of 800 billion barrels of extremely hard to extract oil. You can read more in Shale Oil: Blood From A Stone?

 

Investing In Oil

When it comes to investing in oil, most investors already do it ... to some extent.

The S&P 500 has around a 12% weight in energy stocks, and to be clear, "energy stocks" almost always means "big oil." Exxon and Chevron alone make up 5% of the index, and other big-share companies like General Electric have significant investments in oil as well.

But with energy playing a bigger and bigger role in global growth, many want to invest directly in oil. If that's your goal, you've got two choices.

 

Buy Futures

The first is to just buy futures contracts. Note: A sustained position in oil futures or an oil futures ETF will NOT track the price of oil that you hear about on TV; there are the issues of contango, backwardation and interest income to consider. We cover the hows and whys of futures vs. alternatives here, and encourage you to read that before you invest.

Both the WTI futures contract and the Brent futures contract are highly liquid and easily accessible, and are used both by not only producers and refiners but also (increasingly) by speculators. Investing in futures contracts, of course, means dealing with issues of contango/backwardation - which has been especially complicated and volatile in the energy markets. We've covered this issue in detail as it's evolved, but let's just say Oil can't make up its mind about the contango issue.

 

Buy ETFs

Even if you don't want to invest directly in futures, there are ETFs that will do it for you. If you're investing in a commodities index, you've got even more exposure to oil. The Goldman Sachs Commodity Index (as presented in the iShares GSG ETF or the iPath GSP Note has roughly 55% of its assets in WTI and Brent oil futures contracts, and 75% in energy overall.

The US Oil Fund (USO) and iPath S&P GSCI Crude Oil Total Return ETN (OIL) give you a pure-play exposure to crude oil futures contracts. Alternatives include Claymore's Oil Up and Oil Down ETFs, which, if nothing else, are so accurately named as to leave little doubt as to the bet being made.

 

Buy Company Shares

Beyond investing in crude oil futures, you can also access this market by investing in oil producers, or in the companies that supply and support the oil-producing industries. You can go buy shares of Exxon Mobil (XOM) on your own, or you can invest in any number of energy- and oil-related mutual funds and ETFs. Of note are the Oil Services Holders (OIH), the iShares Oil Equipment ETF (IEZ) and Oil & Gas Exploration and Production SPDR (XOP). These equity ETFs are, for many people, easier to understand than futures-based alternatives, and may also have tax advantages over futures positions.

 

Other Energy Commodities

Oil's the big dog in the energy field, but it's not the only play. Natural gas, gasoline, heating oil and other distillates all compete for attention ... and for the dollars of investors.

 

Natural Gas

After oil, natural gas has the second most active futures market in the energy space, and is probably the second most important energy source globally. Natural gas is created by the anaerobic breakdown of organic material; as plant and animal matter rot, natural gas is created. The gas is primarily methane, but contains other gases as well: ethane, butane, etc.

Gas is often found in conjunction with oil at oil fields; those flames you see are natural gas vents. Oil companies that are unprepared to harvest gas simply burn it off to get rid of it. Aside from oil fields, it can also be found in stand-alone natural gas deposits, coal beds or even landfills. The largest producers are the U.S., Russia, Finland and the U.K., but the largest reserves are located in the Middle East; Qatar has an offshore field with over 900 trillion cubic feet of gas.

Natural gas supporters say that it is a cleaner-burning fuel, and that it is found in more geopolitically stable regions of the world than oil; detractors point out that it can explode, and that pick-up of interest in natural gas has been slow.

The natural gas markets tend to be extremely volatile, with prices often swinging on average over 2.7% per day, according to the IEEE. Natural gas' monthly standard deviation is also larger (51.8%) than oil (38.9%), according to the same statistics. Pricing trends are also strongly seasonal, with prices tending to rise in September in anticipation of the Northeast winter, and then fall in the summer.

The biggest players in the natural gas market are EnCana (ECA), XTO Energy (XTO) and EOG Resources (EOG), although there are many other smaller players. Beyond that, investors can tap into the market through the US Natural Gas ETF (UNG), which holds a rolling futures position in natural gas. The iPath Natural Gas ETN (GAZ) offers another choice.

NYMEX: NG

 

Gasoline

We all know about gasoline. The price of gasoline hits almost every American directly at the pump. And while those prices incorporate a lot more than just the spot price of gasoline on the futures market, including taxes and the gas station profit, we should all care about gas futures prices because they impact us directly.

Gas is an oil distillate, meaning it is created by distilling down crude oil at an oil refinery. As such, prices are linked to the price of crude. The relationship is not exact, however, because the cost and profit of refining oil into gas varies over time. The difference between the price of oil and the price of gas is called the "crack spread," referring to the process of "cracking" oil down into its different parts: gas, heating oil, aviation fuel, kerosene, etc.

Many attribute the current high price of gas not just to the high price of oil, but to constraints in the U.S. refining industry. Few-to-no new oil refineries have been built in the U.S. in the past few decades, due to (depending on whom you ask) NIMBY politics or the desire by big oil companies to lock in fat profits in the refining center.

As far as investing in gasoline, a U.S. investor's best choice is to access the market directly via the futures market; the leading gas contract is the NYMEX's RBOB Gasoline (RB), which incorporates a 10% ethanol blend.

 

Heating Oil

Heating oil is the final player in the market, and like natural gas, is known for a seasonal trading pattern tied to the ebb and flow of the New England winter: prices tend to jump in the fall in anticipation of winter demand, and fall off in February and March as need for the fuel falls.

Heating oil trades in the largest volume on the NYMEX under the ticker HO.

 

Coal

Coal gets special mention. It is a critical energy source, particularly in the U.S., which is richer in coal than in any other type of fossil energy. But for a variety of reasons, coal futures do not currently exist - at least not a truly liquid market for coal futures. Investors interested in playing with this dirty old fuel are left buying the shares of coal-mining companies like Arch Coal (ACI) or Peabody Energy (BTU).

There's a great deal of interest currently in developing cleaner-burning coal, although this remains more rhetoric than reality. Still, people are investing huge sums of money to make it happen, and if it does, coal use (and prices) could jump significantly.

 

NEXT UP: Alternative Energy

Enough with sludgy oil and smelly natural gas; let's talk about the green stuff: alternative energy.