Fundamentals of Trading NYMEX Energy Futures

By Dominick A. Chirichella, Energy Management Institute

July 2006

Dominick Chirichella of the Energy Management Institute presented a 90-minute online seminar on the fundamentals of trading energy markets using NYMEX energy futures, now available on the CME Globex® electronic trading platform. Drawing on 35+ years working in all facets of the energy complex, Mr. Chirichella tailored his broad industry knowledge to the perspective of an energy trader and offered insights on how to establish risk parameters and identify market opportunities.

Lind-Waldock presents an edited text of the online presentation given June 22, 2006, here. You can view the full presentation, Fundamentals of Trading NYMEX Energy Futures, at no charge.

Energy Market Drivers and a Look at History

Energy is a tremendous market, it's got all of the right ingredients from a trading perspective. It's highly volatile, has wide trading ranges, and there are lots of drivers affecting it. These include:

OPEC
Geopolitics
Weather
Technical factors

From a fundamental point of view, I'd like to look at history to help us determine where we are today and where we might be heading. In 1969, the price of crude oil was about $1.01 a barrel. It was quite a boring, mature industry. Pre-1970, it was very much a fundamentally driven market. We had an incident in Suez and the formation of OPEC in the late 1960s, but in 1973, the world really changed for energy. It really wasn't until the first oil embargo in 1973 that we saw, for the first time, the energy market was more than a supply-and-demand market. There were geopolitical implications determining where prices were going. We saw the first big, big price spike. The price of oil went way up--almost $11 a barrel. It was a huge move, and it did not come unnoticed. It had a big impact on the economy. The developed economies of the world were still very much manufacturing-oriented economies, so the implication of surging energy prices had a quick impact, and the elasticity of demand started setting in.

Then we had the mother of all geopolitical events in 1979, the Iranian revolution. The price of oil went up to almost $40 a barrel, and interest rates were running at 17 to18 percent. Energy and energy trading went through its first shift. During this time, the first NYMEX energy product was launched.

We went through the first half of the 1980s in a recessionary area, and the price of crude oil drifted back to around $10 a barrel, and that was perceived as a pricing level where it didn't make sense to produce oil. Keep in mind, back in the 1970s and 80s, we had a surplus capacity of oil. That is, oil already discovered and in the ground, with no associated demand. Supply had been driving the market, because of surplus capacity of about 14-15 million barrels a day during this time.

Then in March 1999, the oil complex saw a really drastic change. OPEC finally got its act together and managed to institute a policy that was acceptable to all 11 members. The member countries recognized they were the world's manager of inventory. They figured out that if they could keep the flow of inventories at fixed levels, prices would stay firm and have a higher probability of surging higher than lower.

Until the early part of 2000, just in the United States alone, more than 100 million barrels were depleted, and inventories were below where the market was accustomed. Then we got into the 2000s, and all of a sudden, OPEC's job was becoming easier and easier. Surplus capacity was coming down.

One of the biggest factors at play today is the tremendous growth in energy use in undeveloped parts of the world, such as China, India and South America. And even in the more developed part of the world (the United States) hardly a year has gone by that we haven't increased demand. Gasoline demand is still robust, even at more than $3 a barrel retail.

What's Next for Energy?

In today's world, we are now consuming 85 million barrels of oil a day. Surplus capacity estimated at 1 to 1.5 million barrels a day. Demand has outstripped supply.

In the '70s, '80s and '90s, we had so much surplus capacity, the amount of investment dollars that went in to bringing in new energy sources was very, very low. And we are seeing the same situation in other traditional commodities. Due to a lack of capital investment in the 1970s and 1980s, it's going to impact us today, because demand is taking off. Since 1999, energy prices have been in a massive uptrend. Surplus capacity is going down. Alternative fuels are feasible solutions, but not realizable for about 10 years or so.

So the environment we are in now is exciting from a trading point of view. All you need to do to see that is to look at the trading ranges today versus the trading ranges we had pre-1999. Crude oil is the primary feedstock that goes into manufacturing. It has no value until it's converted into a usable product, such as gasoline or heating oil. We have not built a new refinery since 1976. Capacity has been expanded, but no new facilities have been built. At the same time, we have more and more environmental restrictions.

We know OPEC has only one goal. It can't raise production anymore because oil product is almost at capacity. The only thing it can do is put a floor in the market. OPEC can cut production when price levels go below what it deems low, about $55-$56 a barrel.

Demand has been growing every year and is not going away tomorrow. China is moving to a manufacturing economy from an agricultural one, and we know that's very energy intensive. In 2005, China imported 43 percent of its energy needs, about 6.6 million barrels per day. This year's forecast is about 7 million barrels per day, and China is second only to the United States as a world consumer of oil. By 2025, it is projected China will be importing 75 percent of its energy needs.

As described before, it's the surplus capacity that's going down. That's why crude oil is in a long-term uptrend. That's why volatility is so high. That's why every single time you see a geopolitical event even talked about, it raises the price of oil 50 cents a barrel.

Data to Watch

The most important piece of data you should be watching as you trade energy markets is the weekly inventory.

Energy Information Administration (EIA) Total Crude Oil and Product Inventories come out every Wednesday morning at 9:30 a.m. CT. There are two sources of oil inventories. The API market is one the market doesn't pay much attention to; it pays more attention to the EIA. These are commercial inventories and the data doesn't include strategic reserves. Go to the EIA's Web site at www.eia.doe.gov for the data. The EIA also releases natural gas inventories every Thursday at 9:30 a.m. CT.

Other reports to watch include the monthly U.S. and world supply/demand report from the International Energy Agency (IEA). They release an energy outlook around 10th to 12th of each month. Go to www.iea.org to see the oil market report.

Weather is also an important influence on the energy markets. A weather outlook is released daily around 2:30 CT on the National Oceanic and Atmospheric Administration (NOAA) Web site, www.cpc.ncep.noaa.gov/products/forecasts. We still don't have full production of natural gas or crude oil back from last year's hurricane season, and the forecast for this year is for another active season. NOAA's 2006 outlook indicates an 80 percent chance of an above-normal hurricane season, a 15 percent chance of a near-normal season, and only a 5 percent chance of a below-normal season.

Another way to help determine whether energy demand will continue is to follow the Standard & Poor's 500 Index (U.S. stock market). If the economy turns down and earnings turn down, then demand growth should slow.

Bullish Fundamental Drivers
Little spare capacity available
Relatively low forward cover
Lingering hurricane supply losses
New hurricane season
Other possible supply disruptions
Iran geopolitical events
Nigeria geopolitical events
Iraq geopolitical events

Bearish Fundamental Drivers
Slowing economic and oil demand growth
Some demand destruction due to high prices
Rising inventories (seen right now as needed surplus capacity)

You can now tap into the power of NYMEX energy products on the CME Globex® electronic platform. Lightning-speed, transparency, and accessibility are Globex hallmarks. NYMEX miNY contracts offer you access to the dynamic energy markets with affordably priced products (1/2 to 1/4 the size of the standard NYMEX energy contracts) with reduced margin requirements.

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Open a new, self-directed account and get started trading NYMEX miNY energy futures with 20 commission-free NYMEX miNY contract sides today!

NYMEX miNY energy futures contracts available:

NYMEX miNY crude oil
NYMEX miNY heating oil
NYMEX miNY gasoline (RBOB)
NYMEX miNY natural gas
NYMEX miNY brent crude oil

For more information on these products, go to www.nymexoncmeglobex.com. You can reach Dominick at 646-202-1433, or via email at dchirichella@emimail.org. Visit the Energy Management Institute at www.energyinstitution.org.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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