Crude oil prices fluctuate with market sentiment and have close relationships with many other assets. Crude oil moves in tandem with other petroleum assets and commodities. Crude oil is also related to the Canadian dollar and the Norwegian Krone. Crude oil is also quoted most often in U.S. dollars, which means a forex relationship occurs as the dollar fluctuates. Crude oil is one of the most critical energy sources. Oil is used to make gasoline and diesel fuel, and the residual oil is used to run turbines to produce electricity. There are several different types of crude oil, including the most extensive benchmarks, which are West Texas Intermediate and Brent. Oil prices are also volatile. They are essential for energy consumption, and higher prices can spill over and generate higher energy spending fueling inflation.
What is Crude Oil?
Crude oil is a fossil fuel composed of hydrocarbons and organic material. You can view crude oil as the remains of animals buried in the ground for millions of years. Crude oil is a non-renewable source of energy, and once consumed, it evaporates. Crude oil is raw oil that comes from the ground. Crude oil is a global commodity that trades physically and as a derivative. Crude oil is measured by its heaviness, a formula that describes its gravity called API. Its sulfur content also measures it. When crude oil is referred to as light and sweet, the gravity is light, and the sulfur content is low. Crude oil is also fungible. Fungible crude oil means that you can deliver oil with the same gravity and sulfur content anywhere in the world.
Crude oil is used to make refined products and is rarely used in its raw form. Crude oil is refined to make other oil products that consumers use. First crude oil is heated and sent to the following process for distillation. It is separated by boiling point and pressure, which allows crude oil to become different products such as gasoline, diesel, and heavy fuel oil and specialty products such as asphalt. Once the new products are created, they are shipped through pipelines, ships, rail, or trucks to their final consumer. For example, a refiner will purchase crude oil and then make gasoline, which could be trucked to a local gas station to be used by a consumer. Crude oil investing incorporates the supply of crude oil and the demand for final products like gasoline.
Do Changes in Crude Oil Prices Impact Gasoline?
Crude oil and refined products move in tandem. Crude oil is the main component of gasoline and makes up about 70% of the price a consumer receives at the pump. The difference is the refining margin and taxes a country or state charges. The changes in the price are correlated, which means that the movements are in tandem with each other. Gasoline, diesel, and other refined products correlate with crude oil movements. The supply of crude oil helps drive the price of refined products, and the demand for refined products helps drive the price of crude oil. Oil prices are driven by macro factors like the change in the economic climate and supply factors, such as how much a company or country can pull out of the ground.
Does Forex Impact the Changes in Crude Oil Prices?
The demand for products like gasoline and changes in the forex market impacts crude oil. Most of the crude oil worldwide is quoted in U.S. dollars. Changes in the dollar's value will affect the price of crude for countries and consumers that purchase oil in other currencies. For example, if the dollar value increases by 5% versus the Euro, then the value of crude oil in Euros will increase by 5%, with all other factors remaining the same. Usually, when this occurs, a commodity like crude oil will adjust lower to incorporate the rise in the dollar value of crude oil.
Higher crude oil prices will also impact other currencies. When oil prices are elevated, the amount of U.S. dollars received by Canadian firms that produce crude oil rises as exports increase. In this instance, the supply of U.S. dollars flowing into Canada will be high relative to the supply of Canadian dollars, which generates an increase in the value of the Canadian dollar. The reverse is true if the price of crude oil is low.
Most of the crude oil in Canada is produced through oil sands. This oil is thick heavy oil mixed in with other materials and must be refined even before the initial refining process.
Another currency that is impacted by the price of oil is the Norwegian Krone. Norway is a significant oil supplier to the global market, and nearly all of the oil produced in Norway is exported. If oil prices are high, the value of the Norwegian Krone will be elevated. If oil prices are low, the reverse will likely be confirmed.
Are Other Commodities Correlated to Oil?
One commodity that has properties similar to oil is natural gas. Natural gas is used to generate electricity and heat homes. It is also used for industrial purposes. Natural gas can be found near oil wells, but new drilling developments such as fracking and horizontal drilling have changed the returns dynamic where the two commodities are limited correlation. In many areas where natural gas is not produced, such as in Europe and Asia, the correlation between natural gas and oil is still relevant.
How is Oil Traded?
Oil trading occurs in the physical market, where producers and refiners trade the underlying product. Oil also has a well-developed derivatives market. The most common ways to trade oil are through futures contracts, CFDs, or the over-the-counter derivatives market. A futures contract is the obligation to purchase crude oil at a specific future date. A contract for differences (CFD) is a security that tracks the movements of oil prices and provides a security that moves in tandem with the underlying price. The over-the-counter market is where there is an exchange of cashflows in the form of a derivative swap.
There are two major benchmarks for oil trading. In North America, the benchmark is West Texas Intermediate (WTI) crude oil. The global standard for crude oil is a basket of crude oils called Brent Blend.
Some futures contracts are traded on the Chicago Mercantile Exchange and the Intercontinental Exchange. The contracts are very liquid and provide traders with a vehicle to hedge and speculate on crude oil movements. Brent blend crude oil and WTI crude oil are considered light sweet crude oils that are good for making gasoline and diesel fuel.
Over-the-counter transactions are generally swaps, which are an exchange of cashflows that are settled against an index. The index is often a futures contract, like WTI crude, but the index could also be specific locations like Oman or Los Angeles.
Contracts for differences generally track the movements of a futures market, but they might also track the changes in an index. There are several benefits to trading CFDs. Instead of posting the cost to buy the underlying product, you can take advantage of the leverage CFD brokers offer. Leverage allows you to post only a fraction of the cost. For example, if WTI oil costs $80 and you receive 10-1 leverage, you only need to post $8 to purchase a barrel of oil.
The Bottom Line
The upshot is that oil is a critical energy source that drives many different assets and is impacted by the forex movement. When oil prices are high, more dollars will flow into countries such as Canada and Norway, which are prominent oil producers. When oil prices are lower, the reverse is true.
Oil prices are mainly quoted in U.S. dollars. Like other commodities quoted in dollars, when the dollar moves higher, the cost of oil in currencies other than the U.S. dollar becomes more expensive. When this occurs, the price of oil will usually adjust lower to accommodate the higher cost in dollars. The reverse is true when the dollar declines.
Crude oil also moves with other petroleum-based commodities, such as gasoline, diesel fuel, and heating oil. Crude oil movements make up about 70% of the price of gas. Crude oil is traded in several ways, including futures contracts, CFDs, physical oil, and over-the-counter transactions. Oil prices can be volatile, and as a critical energy source, high prices can generate unwanted inflation and reduce the ability of consumers to use discretionary income.