Alternative Investments Crude Oil as a Short Commodity - Essay Example

Alternative Investments – Crude Oil as a Short Commodity Introduction In commercial contexts, a commodity refers to a basic product that is widely used as a raw material or as an end product across international markets, and that which is interchangeable with other common commodities. Examples of commodities in international markets include but not limited to energy sources like natural gas and crude oil, and precious metals like gold, palladium and diamond. In practical marketing contexts, prices of these commodities can fluctuate erratically. For example, in one month, the price of crude oil per barrel can be $120. In the next month, the price of crude oil could either rise to $130 or fall to $100. Fluctuation in the price of commodities can be attributed to secondary factors like fluctuation in foreign currency exchange rates, and unbalanced supply and demand levels among others. For example, fluctuation in the value of the U.S. Dollar causes significant impacts on crude oil prices. In addition, overproduction of crude oil increases supply over demand, thus tipping prices towards a downturn course (Lindsey 37). Fortunately, investors can use either long position or short position investments in profitably trading with commodities like crude oil. As a thesis statement for this essay, it is undeniable that short position investment in crude oil commodity is a profitable trade in the foreseeable future. Illustrated Example Technically, short investment position entails the process of selling a specific unit of a commodity with the sole expectation that the commodity’s price will fall shortly after the sale, thus re-purchasing the same specific unit at a lower price compared to the selling price. Short investment in crude oil contracts depend on three technical components; ticker symbol, contract value, and the margin requirements. Ticker symbol is the time when the value or unit price of crude oil is expected to take effect. For example, a ticker symbol of CL15K @ $47.60 means that the contract value of crude oil per barrel in May (K) 2015 (15) will be $47.60 per barrel. However, the actual price per barrel of crude oil in May 2015 may be either lower that $47.60 or higher than the $47.60 value (PwC 05). Margin requirement is the percentage margin maintained by a commodity exchange market like the New York Mercantile Exchange. In the business of short position trading, an investor can acquire a contract today to supply 1000 barrels of oil in May 2015. In this case, the investor will borrow 1000 barrels of oil at $47.60 per barrel today costing $47.60 × 1000 = $4760. Shortly after borrowing from the producers, the investor can sell the oil at the same price of $47.60, and wait until May 2015 when the price will be slightly lower than the contract value. When the contract time is due, the price of crude oil may have dropped to $40.60 per barrel (PwC 07). Therefore, the investor will just purchase 1000 barrels of crude oil at $40.60 per barrel and supply it to the contracting customer, thus making a gross profit of $7 × 1000 = $7000 from the short position investment. Based on this illustrative example, it emerges that short investment options in crude oil and other commodities possess a substantial profit potential for private or institutional investors. Trends and Characteristics in Crude Oil Market Admittedly, crude oil is one of the hottest commodities for short position investment in the market today. First, crude oil is a highly liquid commodity whose market trends are characterized by many active customers and substantial transparency in price fluctuations. From 2014 to 2015, changes in the unit price of crude oil are primarily attributable to lack of balance between the economic elements of supply and demand. Secondly, the contract price of crude oil in international markets has been projected monthly for the foreseeable future; until up to the year 2025. Presently, the contract value of crude oil in June 2015 will be $49.31. In July 2015, the contract value will rise slightly to $50.73 per barrel (NASDAQ 01). However, the actual barrel price of crude oil in June and July is expected to fall below $49.31. Therefore, short position investment seems to be the most lucrative commercial undertaking within the crude oil commodity sector. In the succeeding paragraph, an elaborate analysis of expected trends and characteristics in crude oil market will be conducted. In 2005, the price of crude oil per barrel hit an all time high at $180. The rise of crude oil prices in 2005 was attributed to low supply coupled with a corresponding high demand of the commodity. Approximately 63% of accessible oil in the world is in the Middle East nations on Iraq, Saudi Arabia and Kuwait (Lindsey 71). In 2005, the war on terror in the Middle East reduced oil production levels, leading to shortage in supply and a corresponding increase in demand. Presently, U.S. troops are heavily withdrawing from the war on terror fronts in the Middle East. Gradual end of the war has led to increase in production of crude oil in nations like Iraq. Actually, the current overproduction of crude oil rose from 1 million barrels per day in February 2014 to 2.5 million barrels per day in February 2015. As a result of excess supply, the price per barrel has dropped to approximately $50 (PwC 07). Besides rise in supply inventories, crude oil prices are expected to drop further because of alternative sources of energy. Presently, U.S. and other Western nations are loosening their stand on the Iran nuclear energy program. In addition, solar technology is gradually taking over as another alternative source of energy. Expected Risks In this case, the synergistic effect of crude oil overproduction coupled with rise in alternative sources of energy will drive crude oil prices to an all time low. In fact by the end of 2015, the actual price of crude oil per barrel may be as low as $20, while the contract value for the crude oil commodity in December 2015 will be $54.83 (NASDAQ 01). Apparently, the probable difference between contract value and actual value of crude oil at the end of the year will feature as a highly lucrative short position investment for commodity investors. However, short position investment in crude oil is not without risks. Like any other commodity, the price of crude oil can take an undesirable turn unexpectedly. For example, by December 2015, the price per barrel of crude oil may have risen to $60.00 or even higher as opposed to dropping. Among the probable causes of rise in crude oil prices include but not limited to the swift rise of the terror group ISIS in the Middle East nations, and the potential exhaustion of crude oil as a natural resource in production areas (Lindsey 62) Undeniably, the current fighting in the Middle East coupled with potential crude oil depletion will invariably cause shortage in supply, and a corresponding rise in demand and prices. In such circumstances, short position investment in crude oil will become immaterial. Risk Mitigation As a smart investor, one should take necessary precautions meant to prevent detrimental loss in case of severe price fluctuations in commodity trading. For example, rise of oil price to $100 per barrel in December 2015 compared to a contract value of $54.83 per barrel will lead to a substantial loss for short position investors (NASDAQ 01). In this case, one security blanket to adopt would be crude oil binary options. In crude oil trading, binary options not only limit the risk exposure, but also acts as indicators of market fluctuations. Technically, binary options are like a gamble, though they prove advantageous and provide a considerable shielding effect in uncertain circumstances. For example, the entry price for crude oil could be set at $49.00 per barrel. Because of an expected fall in barrel price, the exit binary option can be set at $25. Immediately the crude oil price per barrel falls to exactly $25, the investor receives a 100% pay off from the binary option contract, which in this case will be $49.00 - $25.00 = $24 per barrel. Based on the current trends characterizing the crude oil market, binary option will be a perfect security for the commodity trade. In this regard, it is evident that a short position investment in crude oil will be a profitable trade in the next few years. Works Cited Lindsey, Sandra. Trading Commodities and Financial Futures: A Step-by-Step Guide to Mastering the Markets. Pittsburg: FT Press, 2013. NASDAQ. Crude Oil: End of day Commodity Futures Prices Quotes for Crude Oil WTI (NYMEX). Nasdaq.com, April 1, 2015. Web, April 1, 2015. http://www.nasdaq.com/markets/crude-oil.aspx PwC. “Perspectives on Trends in Commodity Risk Management Operations: Commodity Trading and Risk Management.” Price Waterhouse Coopers Report 3.5, (2014): 04-12. Read More