Fear of Missing Oil – Economics and Trading of Commodities
By Ethan Sa and Isaac Oh, (edited by Eshan Gupta)
When Russia invaded Ukraine, the thought of a nuclear war (though certainly a major worry) shared the stage with another nightmare scenario for world leaders: a major reduction of supplies of oil. See, Russia is the world’s second largest producer of oil, up there with the United States and Saudi Arabia. Most European countries get most of their oil from Russia. Oil concerns, however, are not new to this conflict. They have, in fact, become an often discussed topic in circles of foreign policy. So why do people care so much about a combustive black liquid? And what does it mean for us consumers?
Although oil has been around for thousands of years, its uses were only exploited recently. In the late 1800s, people began using oil to light lamps; a guy named John D. Rockefeller brought in lots of money and a good deal of criticism when he created the Standard Oil Company, which at its height sold almost all the oil people were buying. Oil industries also got a boost by the introduction of the internal combustion engine. When Henry Ford made cars cheap enough for everyone to buy, oil companies jumped at the opportunity to make them run. Standard Oil would later be broken up by the government because it controlled too much of America’s oil production, but it remains with us today; Exxonmobil and Chevron are among its descendants.
By the 1900s, oil had become an extremely important commodity used worldwide, as it remains today. From the gasoline we use in our cars to the energy created by power plants (think electricity, which we need for pretty much everything), oil is crucial to the world economy. When oil prices raise, it leads to more expensive electricity and fuel, which leads to more expensive transportation and running of machines. Reacting to higher costs, businesses increase the prices of their products which lead to less buying and less spending. The combination of rising energy and fuel costs can have a detrimental impact on an economy as the oil prices can have a trickle down effect on many aspects of commerce and trade.
This is why the economy suffers as people spending on goods is what drives the economy. In 1973, Arab state members of OPEC (Organization of Petroleum Exporting Countries) decided to limit oil exports to certain countries who were supporting Israel in the Yom Kippur War. The restriction of oil exports had a major impact on western countries such as the United States. The result? Among other things, gas prices went through the roof. Massive lines formed at gas stations, and prices in the rest of the economy began to rise as well in what’s called supply-shock inflation. Things got even worse for American energy when Shah Mohammed Reza Pahlavi of Iran, a major oil producing country, was overthrown and replaced by the regime of Ayatollah Ruhollah Khomeini, which was more hostile towards America.
Today, yet another example of the world’s dependence on oil is the current situation in Europe. Europe depends on natural gas from Russia to produce energy and heat homes. Because Europe relies so heavily on Russian gas, it cannot completely stop buying Russian oil; doing so would mean massive price rises in all sorts of European goods. Restrictions in the availability of oil will cause energy prices to rise which would affect nearly every sector of the world economy. Thus, history has shown the importance of oil which cannot be understated as every person on Earth relies on it for survival.
So, if oil’s so important, how can you get on the trend? Oil falls under a class of investments known as commodities. Commodities are fungible goods which have no unique qualities and thus, are interchangeable. For example, gold mined by different companies are identical and can replace each other, which makes gold a fungible good. One way of investing in commodities like oil is by investing in options or futures. The idea behind options is that it is impractical to physically buy large quantities of a commodity. An options trader in New York, for instance, does not have a place to store dozens of oil barrels. Thus, one can sign an agreement giving them the right to purchase or sell some amount of the commodity at a certain price in the future (for a price). If you think oil prices are going up in the future, you’re going to want to invest in a call, which gives you the right to buy at a specified price in a specified time period. Conversely, if you’re anticipating a decline in oil prices, you should go for a put, which allows you to sell at a specified price in a specified time period.
You can also invest in futures, which are contracts that obligate buyers to buy or sell something at a certain price and time. If you want to invest in oil futures, you should probably be sure oil prices are going to rise; otherwise, you may have to buy oil above its market price and spend more money than you otherwise would have. Additionally, commodity ETFs can be a great way to invest in commodities as ETFs are a diversified portfolio that can follow the performance of multiple commodity indexes. A simpler way of investing in a commodity would be to invest in a stock which provides an indirect way of investing in commodities. You can buy stock in companies that are major producers of oil and gas, like British Petroleum or Exxonmobil.
With oil being a crucial natural resource, it could be a great commodity to invest in. Oil is critical to sustaining civilization and is far from being replaced in the next 30 years, despite world leaders’ wishes. Although renewable energy is on the rise, energy sources such as wind and solar have not matured enough yet to provide the reliable and plentiful energy that oil provides to countries around the world. A good example of this is the energy crisis in the United Kingdom in 2020. In 2020, the United Kingdom experienced a major shortage of electricity after North Sea winds slowed, which led to wind turbines producing less power. However, a potential downfall of oil is its short term volatility and long term questionability. The current war in Ukraine is a prime example of this volatility; oil prices shot up once Russia was sanctioned by allies of Ukraine because of how much oil Russia produces (remember supply-shock inflation?).
Similarly, they trembled in 2020 after Saudi Arabia and Russia engaged in a competitive price war (where they each priced their oil lower than their competitor). There are also questions of morality; if you’re someone who really cares about the environment, investing in oil might be anathema to your moral compass. Additionally, many world leaders have pledged to reduce carbon emissions—like those made from burning oil—by investing in renewable energy, so oil’s days may be numbered. To conclude, oil can be a good investment if you’re looking at a fairly long time frame; however, if you’re trying to get rich quick or invest in something very long lasting, or if you care a lot about the environment, it may not be the investment for you.
