Whether you’re thinking about investing in the energy sector, trading energy commodities or just plain curious, there’s no doubt that energy trading is big business.
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Traders keen to capitalise on the projected future growth of the energy market should also be wary of the volatility that affects this sector. Many people are asking how to trade energy, and there are some key things that you should know first.
Table of contents
How Big is the Energy Market?
In a word: big.
Most of us are familiar with fossil fuels like gasoline and diesel, but the energy market goes well beyond transportation. In addition to fossil fuels, the energy market also incorporates natural gas liquids, electrical power, nuclear power, and renewable energy.
Commodity assets such as crude oil, natural gas, and electrical power are traded around the globe. In addition, the companies that produce, refine, transport, store and consume energy are actively traded on stock exchanges around the world.
Global energy consumption reached 13.86 billion metric tons of oil equivalent in 2018, a figure that has risen by 47% since 2000.
Is Energy Demand Growing?
The IEA also sees total energy demand growing by 25% until 2040 The different segments of the energy markets are expected to see diverging growth patterns in the future. During the next decade, oil growth is expected to continue to climb according to the International Energy Agency (IEA).
Global oil growth demand is expected to increase into the 2030s and then begin to decelerate. The EIA believes that oil demand will increase by about 1 million barrels per day on average every year to 2025, from 97 million barrels per day in 2018.
During the short-term, in the aftermath of the global COVID-19 pandemic, demand is expected to decline significantly. The US Department of Energy (DOE) sees fossil fuel consumption down 7% year over year and expects demand to fall 9% during 2020. The DOE expects energy demand to rebound 5% in 2021.
Natural gas production is also expected to decline in 2020. The DOE sees natural gas production averaging 89.8 BCF per day down 3% year over year from 92.2 BCF per day.
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Electrical power and renewable energy are sectors that are continuing to expand. The IEA sees renewable energy accounting for half of the rise and natural gas for 35%.
The US Department of Energy reports that U.S. annual energy consumption from renewable sources exceeded coal consumption for the first time in its history in 2019.
This scenario has played out as coal consumption to generate electricity that has dwindled while solar and wind electricity generation has increased.
The EIA believes that coal consumption in the United States decreased by nearly 15%, and total renewable energy consumption grew by 1%. For 2020, EIA expects that coal generation will fall by 25%.
Renewable energy is consumed by every sector in the United States. The majority, approximately 56% of renewable energy is used for electricity, driven by hydroelectric power. Additionally renewables are consumed in industrial, transportation, and residential.
The agency believes the increase in electric cars will be a headwind for oil growth and drive electricity growth. The EIA believes that by 2040 there will be 330 million electric cars on the road up from an estimate of 300 million in 2018. That would displace approximately 4 million barrels a day of oil use.
According to Bloomberg, electricity demand will increase by 25% by 2050 to 38,700 terawatt-hours from 25,000 terawatt-hours in 2017. Most of the gains will come from China, closely followed by India. Approximately 9% of electricity demand will be driven by electric cars.
In the short-term, the US Energy Information Administration (EIA) expects US retail sales of electricity in the commercial sector will fall by 6.5% in 2020 because of the quarantine that forced many businesses to close.
Is Energy Supply Rising or Falling?
Ahead of the spread of COVID-19 throughout the globe, energy production had been on the rise. In the wake of the pandemic, planned spending in the energy sector has dropped significantly.
The declines occurred as exploration and development planned expenses dropped from a 4-year high. In a low priced trading environment global expenditures can drop significantly.
The Energy Information Administration (EIA) sees expenditures dropping to $10 per BOE from $20 per BOE of oil and gas prices remain at current levels. This follows a 13% increase in 2019 to $361 billion according to the EIA. This will put downward pressure on production. In the United States alone, US crude oil production has declined from 13.1-million barrels of oil per day down to 11.4-million barrels a day from early-March 2020 to mid-May 2020. This represents a 13% drop in output.
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How to Trade Energy Commodities
The changes to supply and demand for energy globally presents an opportunity to trade these markets. Shocks generally generate price spikes or troughs, which eventually recover. Several strategies can be used to trade energy products, including evaluating supply and demand, measuring one energy product versus another, as well as using technical analysis.
Several different financial products can be used to initiate risk in energy. This includes futures, ETFs, over the counter contracts, CFDs, as well as, the shares of the public companies that produce, store, move and consume energy.
How to Trade Fossil Fuels
Fossil fuels such as oil, gasoline, heating oil, gas-oil, residual fuels, coal, and natural gas have active to relatively active futures markets. A futures contract is the obligation to either buy or sell an asset at a date in the future. A futures contract has a fixed volume and trades on a regulated exchange. The two most active energy exchanges are the Chicago Mercantil Exchange (CME) and the Intercontinental Exchange (ICE).
Global crude oil benchmarks such as the Brent oil futures contract (which incorporates several North Sea crude oil) are actively traded on ICE. Brent is a worldwide benchmark with approximately 70% of global crude priced off the benchmark. ICE also offers a Middle East benchmark.
Dubai is the Asian benchmark for Middle East crudes as approximately 1.7 million barrels per day of crude this crude oil is produced making it a reliable benchmark. You can also trade several different refined oil products on ICE. This includes European and Asian Gasoil (which is heating oil), as well as jet fuel and naphtha.
The oil and refined products that are traded on ICE are both financially settled and physically delivered. Many of the futures contracts provide the option to exchange the financially settled instrument for a physical transaction delivered to an ICE regulated storage facility.
Most of the fossil fuels that are traded in the United States are transacted on the CME. The West Texas Intermediate crude oil contract (WTI) has the highest liquidity of all the oil futures contracts. Each oil contract has a specific sulfur content as well as density. WTI is a light sweet crude with low density and low sulfur content. It is used to make gasoline as well as distillates which include heating oil and diesel fuel.
The WTI contract that is traded on the CME is physically delivered. Each contract requires delivery of 1,000 barrels of WTI crude oil, which is equal to 42,000 gallons. The WTI futures contract trades around the clock, 6-days a week. There are 36-consecutive delivery months followed by semi-annual contracts for a couple of years, and then annual contracts for up to 10-years. The WTI futures contract is the benchmark for hedging future production in the United States.
The CME also offers gasoline contracts, heating oil contracts, brent oil contracts, and coal contracts. The energy securities are called oil products and are actively used by refiners to hedge their production exposure. The other side of the trade incorporates airlines, cruise ships, and marketing firms that sell gasoline and diesel.
Another investment vehicle is the exchange-traded fund. This stock-like security is traded on an exchange that allows you to purchase futures contracts or indices that track the movement of some underlying asset. For example, the United States Oil Fund holds WTI futures contracts. Some ETFs hold companies that are active in the energy sector. Some have exploration and production companies, others hold only oil service companies, while some hold refiners.
Over the counter, energy trading is also active. These are private transactions performed between counterparties. These transactions can look just like futures contracts but are not cleared through the exchange. Another financial instrument that provides exposure to energy are Contracts for Differences (CFDs). These are also private contracts listed with your broker that track the movements of energy products like crude oil and natural gas.
Natural gas is widely traded, but it’s less fungible than crude oil since it is a gas. The gas can be liquified and shipped. The liquified version is referred to as a liquid natural gas (LNG). The most actively traded natural gas is in the United States.
The CME natural gas futures contract provides the most liquidity. The delivery point is in Henry Hub Louisiana. Each natural gas contract holds 10,000 MMBTU (million of British Thermal Units).
Natural gas is also traded in the over the counter market, as well as through CFDs. Most of the financial products track the movements of CME natural gas. Natural gas also has an active physical market where traders move natural gas through pipelines across the United States. This active physical market is the key reason for the active financial market. Additionally, some ETFs track the movement of natural gas by holding natural gas futures.
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Electricity and Renewable Energy
Electricity is a local product that is actively traded in the United States. Since you cannot store electricity for more than a few days (via a battery), the price is driven by demand and the cost of supply. The CME provides several active electricity contracts that are based on specific locations throughout the United States. Each electricity contract describes the hub where it will be delivered as well as a specific wattage that will be delivered each day. Electricity also actively trades in the over the counter market.
Renewable fuels include ethanol which is made from corn and is blended with gasoline, as well as biofuels. Biofuels are grain seed oils (like soybean oil), mixed with diesel fuel. These products generally exist for sustainability purposes. Renewable fuels also trade in the over the counter market.
How to Trade Energy Equities
The energy sector as it relates to energy commodities incorporates companies that produce, refine, move, consume, and store energy. This includes:
- Exploration and Production
- Oil and Natural Gas Services
- Pipelines Companies
- Transportation Companies
There are thousands of public companies that engage in these activities. They are listed on stock exchanges throughout the globe. In addition to trading individual equities, you can trade ETFs that hold these companies in a trust. For example, the XLE Spider ETF holds large integrated companies like Exxon Mobile, Chevron Texaco, and Conoco Phillips. Some CFDs track the movements of some of the large oil companies as well as the ETFs that are actively traded.
The Bottom Line
The global energy sector generally expands during periods of economic growth and contracts during recessions. The spread of COVID-19 had a significant impact on energy demand, which will eventually return. The energy industry is vast covering the fossil fuel sector as well as renewable energy and electricity.
While the short-term outlook is mixed, the long term outlook favors the additional use of electricity as a replacement for fossil fuels. Electricity will likely continue to replace fossil fuels used in transportation as electric cars sales expand.
Underlying energy products such as crude oil, heating oil, gas oil, gasoline, natural gas, ethanol, and electricity are actively traded on the Chicago Mercantile Exchange and the Intercontinental Exchange. Commodity assets such as crude oil, are fungible are traded around the globe while natural gas and electrical power are more localized.
Energy is produced and consumed through energy assets, such as refiners and utilities. Companies like these as well as producers and distributors of energy are traded on stock exchanges worldwide. The energy sector is a massive part of worldwide global commerce and will likely continue to change in the decades to come.