Crude oil trading offersexcellent opportunities to profit in nearly all market conditions due to its unique standing within the world’s economic and political systems. Also, energy sector volatility has risen sharply in recent years, ensuring strong trends that can produce consistent returns for short-term swing trades and long-term timing strategies.
Market participants often fail to take full advantage of crude oil fluctuations, either because they haven't learned the unique characteristics of these markets or because they're unaware of the hidden pitfalls that can eat into earnings. In addition, not all energy-focused financial instruments are created equally, with a subset of these securities more likely to produce positive results.
Key Takeaways
- If you want to play the oil markets, this important commodity can provide a highly liquid asset class with which to trade several strategies.
- First, decide what is appropriate for you: a spot oil (and if so what grade); a derivative product such as futures or options; or an exchange-trade product like an ETN or ETF.
- Then focus on the oil market fundamentals and what drives supply and demand, as well as technical indicators gleaned from charts.
Here are five steps needed to make a consistent profitinthe markets.
1. Learn What Moves Crude Oil
Crude oil moves through perceptions of supply and demand, affected by worldwide output as well as global economic prosperity. Oversupply and shrinking demand encourage traders to sell crude oil markets, while rising demand and declining or flat production encourages traders to bid crude oil higher.
Tight convergence between positive elements can produce powerful uptrends, like the surge of crude oil to $145.31 per barrel in July 2008, while tight convergence between negative elements can create equally powerful downtrends, like the August 2015 collapse to $37.75 per barrel. Price action tends to build narrow trading ranges when crude oil reacts to mixed conditions, with sideways action often persisting for years at a time.
2. Understand the Crowd
Professional traders and hedgers dominate the energy futures markets, with industry players taking positions to offset physical exposure while hedge funds speculate on long- and short-term direction. Retail traders and investors exert less influence herethan in more emotional markets, like precious metals or high beta growth stocks.
Retail's influence rises when crude oil trends sharply, attracting capital from small players who are drawn into these markets by front-page headlines and table-pounding talking heads. The subsequent waves of greed and fear can intensify underlying trend momentum, contributing to historic climaxes and collapses that print exceptionally high volume.
3. Choose BetweenBrent and WTI Crude Oil
Crude oil trades through two primary markets, West Texas Intermediate Crudeand Brent Crude. WTI originates in the U.S. Permian Basin and other local sources while Brent comes from more than a dozen fields in the North Atlantic. These varieties contain different sulfur content and API gravity, with lower levels commonly called light sweet crude oil.Brent has become a better indicator of worldwide pricing in recent years, although WTI in 2017 wasmore heavily traded in the world futures markets (after two years of Brent volume leadership).
Pricing between these grades stayed within a narrow band for years, but that came to an end in 2010 when the two markets diverged sharply due to a rapidly changing supply versusdemand environment. The rise of U.S. oil production, driven by shale and fracking technology, increased WTI output at the same time Brent drilling underwent a rapid decrease.
U.S. law dating back to theArab oil embargoin the 1970saggravated this division, prohibiting local oil companies from selling their inventory in overseas markets. This ban was removed in 2015.
Many of CME Group's New York Mercantile Exchange (NYMEX) futures contracts track the WTI benchmark, with the "CL" ticker attracting significant daily volume. The majority of futures traders can focus exclusively on this contract and its many derivatives.Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) offer equity access to crude oil, but their mathematical construction generates significant limitationsdue to contango and backwardation.
4. Read the Long-Term Chart
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WTI crude oil rose after World War II, peaking in the upper $20s and entering a narrow band until theembargo in the 1970striggered a parabolic rally to $120. It peaked late in the decade and began a torturous decline, dropping into the teens ahead of the new millennium. Crude oil entered a new and powerful uptrend in 1999, rising to an all-time high at $157.73 in June 2008. It then dropped into a massive trading range between that level and the upper $20s, settling around $55 at the end of 2017.As of January 2021, it was trading at about $47.
5. PickYour Venue
The NYMEX WTI Light Sweet Crude Oil futures contract (CL) trades in excess of 10 million contracts per month, offering superb liquidity. However, it has a relatively high risk due to the 1,000 barrel contract unit and .01 per barrel minimum price fluctuation. There are dozens of other energy-based products offered through NYMEX, with the vast majority attracting professional speculators but few private traders or investors.
The U.S. Oil Fundoffers the most popular way to play crude oil through equities, posting average daily volume in excess of 20-million shares. This security tracks WTI futures but is vulnerable to contango, due to discrepancies between front month and longer-dated contracts that reduce the size of price extensions.
Oil companies and sector funds offer diverse industry exposure, with production, exploration, and oil service operations presenting different trends and opportunities. While the majority of companies track general crude oil trends, they can diverge sharply for long periods. These counter-swings often occur when equity markets are trending sharply, with rallies or selloffs triggering cross-market correlation that promotes lockstep behavior between diverse sectors.
Some of the largest U.S. oil company funds are:
- SPDR Energy Select Sector Fund (XLE)
- SPDR S&P Oil & Gas Exploration and Production ETF (XOP)
- VanEck Vectors Oil Services ETF (OIH)
- iShares U.S. Energy ETF (IYE)
- Vanguard Energy ETF (VDE)
Reserve currencies offer an excellent way to take long-term crude oil exposure, with the economies of many nations leveraged closely to their energy resources. U.S. dollarcrosseswithColumbian and Mexican pesos,under tickers USD/COP and USD/MXN, have been tracking crude oil for years, offering speculators highly liquid and easily scaled access to uptrends and downtrends. Bearish crude oil positions require buying these crosses while bullish positions require selling them short.
The Bottom Line
Trading in crude oil and energy marketsrequiresexceptional skill sets to build consistent profits. Market players looking to trade crude oil futures and its numerous derivatives need to learn what moves the commodity, the nature of the prevailing crowd, the long-term price history, and physical variations between different grades.
