Lesson 2 Activities

Introduction to Fundamental Factors Activity

Read each of the factor examples and scenarios given below for crude oil and then for natural gas. For each scenario, determine whether it could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price. When you are finished with the scenarios, synthesize them in your own mind to generate a recommendation to buy or sell the commodity.

Keep in mind, these are actual energy commodity contracts and not "stocks". So, you are buying or selling the actual commodity using the financial contracts. These decisions are also about trading for a profit. That is, if you think prices are going to rise, you want to buy contracts now and sell them later when prices rise to make a profit. Conversely, if you think prices are going to fall, you would sell contracts now and buy them back later when prices do fall to make a profit. Buying or selling a commodity contract now is called "taking a position" and then offsetting that with a sell or a buy at a later date is called "closing a position." In order to offset a long position, you can go and sell the same contract in the exchange. And to close a short position, you need to buy back an identical contact.In the Fundamental Factors activities that follow in the weeks ahead, you will be asked to take and close a position in crude oil and natural gas each week. For this week, however, we will warm up by focusing on understanding the various factors influencing crude oil and natural gas prices.

Crude Oil Factor Examples

Read through these factor examples to help you with the scenarios that follow.

1. Weather – Heating oil, a crude distillate, is still used in several homes in the Northeastern US for space heating and hot water. This part of the country is the world’s largest consumer of heating oil. (And many old industrial factories and power plants still use heating oil.)
2. Domestic Economy – The strength of the economy is a good barometer for energy usage overall. Indicators such as the stock market, manufacturing indexes, retail sales figures and unemployment numbers influence the perception of demand.
3. Global Economy - In addition, crude oil has truly become a global commodity, so world economic factors impact oil prices. (The health of the Eurozone, China’s manufacturing, etc.)
4. Currency – The strength/weakness of the US Dollar vs. other currencies directly impacts crude oil prices. Foreign investors trade crude oil contracts, which are priced in US dollars and cents. Thus, if the dollar is weak, foreign investors can buy more crude contracts with their currency. On the other hand, when the US dollar strengthens, foreign investment lessens and crude prices tend to fall. There is a very high correlation between these two.
5. Geo-Political Situations – Unrest in any oil-producing region gives uncertainty to supply, and therefore, to prices. Potential conflict in the oil producing regions gives rise to concerns about crude oil interruptions. For example, consider these hypothetical scenarios: in Nigeria, the rebel group MEND has disrupted the shipment of crude oil by attacking facilities owned by Royal Dutch Shell, the Russia/Ukraine conflict has raised concerns about oil supplies coming from Russia, and ISIS gained controls some oil fields in Syria and Northern Iraq.
6. Cross-Commodity Markets – The price of crude can be impacted by a change in the price of the products derived from oil, such as gasoline and heating oil.
7. Changes in Inventory – The US government reports the change in the amount of crude oil that is in the nation’s storage facilities. Increases in this are deemed to be “bearish” (supplies have increased) while decreases are seen as “bullish” (there was demand for the inventory). See the link to the  "Weekly Petroleum Status Report" in the Resources menu.

Crude Oil Scenarios

Assume the following hypothetical scenarios. Determine whether each scenario could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price.

1. Weather – US forecasts for September call for high temperatures in the Northeast. (Bearish, Bullish, Neutral)
2. Domestic Economy – The Dow Jones Industrial Average fell 500 points today. (Bearish, Bullish, Neutral)
3. Global Economy – The European Central Bank (ECB) loans money to a struggling Greece. And, China sees a large increase in exported goods. (Bearish, Bullish, Neutral)
4. Currency – The US Dollar traded lower against the British Pound and Japanese Yen today. (Bearish, Bullish, Neutral)
5. Geo-Political Situations – ISIS has attacked and destroyed an oil refinery in Iraq while Saudi Arabia continues to increase the supply at lower price. (Bearish, Bullish, Neutral)
6. Cross-Commodity Markets – the "peak" summer driving period is about to start, and Americans are expected to drive 10% more miles than last summer due to lower gasoline prices. (Bearish, Bullish, Neutral)
7. Changes in Inventory – The Energy Information Agency’s Weekly Crude & Distillates Report showed that 1.5 million barrels of oil were added to the nation’s storage facilities last week. (Bearish, Bullish, Neutral)

Given all of these, would you buy crude oil contracts (you think prices will rise, i.e., "Bullish") or sell crude oil contracts (you think prices will fall, i.e., "Bearish")?

Natural Gas Factor Examples

Read through these factor examples to help you with the scenarios that follow.

1. Weather – Until we start exporting natural gas in the form of Liquefied Natural Gas (LNG) in 2015, it remains a domestic North American commodity. It is really not influenced by world events or even the price of crude. So, the biggest factor affecting price is the weather. About half of US homes use natural gas for space heating and hot water. In addition, about 34% of all electricity is generated with natural gas. This amount is actually increasing as the cheaper gas prices of the past several months have led to switching from coal to natural gas. And, as with crude oil, positive economic signals equate to the potential for increased energy usage, which includes natural gas.
2. Economy – The same factors that impact crude oil prices have an effect on natural gas prices.
3. Global demand - The demand and price of LNG in other countries will influence US natural gas producers' decision to meet domestic demand or produce LNG and export it.
4. Changes in Inventory – The US government also reports the weekly change in the nation’s natural gas storage. Similar dynamics to crude inventories apply, except that the projected amount of natural gas in storage as we head into winter is a huge factor in price movement, as the April through October period is when we refill (inject gas into) storage. (See the link to the "Weekly Natural Gas Storage Report" in the Resources menu.
5. Power Generation – The mix of nuclear, coal, hydro, and wind power impact natural gas prices, but weather still dominates the demand for power, and as a result, the demand for natural gas usage. As more and more coal plants are taken offline due to more stringent emissions standards, more natural gas will be used to generate power. Also, some coal plants can burn natural gas if they need to.

Natural Gas Scenarios

Determine whether each scenario could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price.

1. Weather – US forecasts for September call for high temperatures across the “southern tier” states. (Bearish, Bullish, Neutral)
2. Economy – The Dow Jones Index rose +100 points today and the S&P gained +15 points. Unemployment increased, but the Consumer Price Index (a measure of inflation) fell. (Bearish, Bullish, Neutral)
3. Global demand - Several latest studies all suggest that there will be a warm winter for Europe, and EU countries have built up a high natural gas stock.
4. Changes in Inventory – The Energy Information Agency’s Weekly Natural Gas Storage Report showed an increase of +85 billion cubic feet. While this was more than forecasted, total gas in the ground is still -5% below last year’s level. (Bearish, Bullish, Neutral)
5. Power Generation – Eight of the nation’s nuclear power plants are offline for maintenance and refueling ahead of the anticipated summer peak load, while coal plants continue to burn cheaper natural gas. (Bearish, Bullish, Neutral)

Given all of these, would you buy natural gas contracts (you think prices will rise, i.e., "Bullish") or sell natural gas contracts (you think prices will fall, i.e., "Bearish")?

Trading

Please answer the following two questions:

1. Suppose that you believed that natural gas factors were bullish. Would you buy or sell natural gas contracts now? How would you close out your position in, say, a week's time?
2. Suppose that you believed that crude oil factors were bullish. Would you buy or sell crude oil contracts now? How would you close out your position in, say, a week's time?

Grading Criteria

This Fundamental Factors activity will be worth 30 points, as per the EBF 301 grading scale described in the syllabus. You will earn two points for each of the crude oil and natural gas factors that you interpret, and 2 points for each buy/sell recommendation that you include and explain in your response. How each factor is going to affect the market (in terms of changes in market supply, demand, and price) has to be explained individually.

You will also earn two points for each of the trading questions that you answer correctly and completely. Your trading suggestion should be based on the overall evaluation.

Quiz

Return to Canvas to take the L2 Quiz.