Crude oil offers high liquidity and excellent 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 because they haven’t learned the unique characteristics of these markets or because they're unaware of the hidden pitfalls that can rob profits. In addition, not all energy-focused financial instruments are created equally, with a subset of these securities more likely to produce positive results.  

Here are five steps needed to take consistent profits from these turbulent markets. Both professionals and novices will benefit by studying these drivers and adding workflows that measure changes in these structural elements. In particular, pay close attention to volume levels and trend intensity, always trying to identify the current crowd and its emotional state.

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. Over-supply and shrinking demand encourage traders to sell crude oil markets to lower ground while rising demand and declining or flat production encourage traders to bid crude oil to higher ground.

Tight convergence between positive elements can produce powerful uptrends, like the surge of crude oil to $145.81 per barrel in April 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 than 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 Between Brent and WTI Crude Oil

Crude oil trades through two primary markets, Western Intermediate (WTI) and Brent. WTI originates in the U.S. Permian Basin and other local sources while Brent comes more than a dozen fields in the North Atlantic. These varieties contain different sulfur content and API gravity, with lower WTI levels commonly called light sweet crude oil.  Brent has become a better indicator of worldwide pricing in recent years although WTI is now more 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 vs. demand environment. The rise of US oil production, driven by shale and fracking technology, has increased output at the same time that Brent drilling has undergone a rapid decrease.

U.S. law dating back to the 1970s Arab oil embargo has aggravated this division, prohibiting local oil companies from selling their inventory in overseas markets.  Those laws are likely to change in coming years, perhaps narrowing the spread between WTI and Brent, but other supply factors could intervene and keep the divergence in place.

Many of CME Group’s 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 derivativesExchange traded funds (ETF) and exchange-traded notes (ETN) offer equity access to crude oil, but their mathematical construction generates significant limitations, due to contango and backwardation.

4. Read The Long Term Chart

WTI crude oil rose after World War II, peaking in the upper 20s and entering a narrow band until the 1970’s embargo triggered a parabolic rally to $120. It peaked late in the decade and began a tortuous 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 145.61 in July 2008. It then dropped into a massive trading range between that level and the upper 30s, remaining within its boundaries into 2015.

5. Pick Your 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 1000 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.  

US Oil Fund (USO) offers 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. iPath S&P Goldman Sachs Crude Oil Trust ETN (OIL) presents an alternative, with an average daily volume greater than 3-million shares but is also vulnerable to similar profit-dampening effects.

Oil companies and sector funds offer diverse industry exposure, with production, exploration and oil services 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.

The five largest U.S. oil company funds and average daily volume (September 2015):

  • SPDR Energy Select Sector ETF (XLE) - 18,401,461
  • SPDR S&P Oil and Gas Exploration and Production ETF (XOP) - 11,735,669
  • Market Vectors Oil Services ETF (OIH) - 7,641,589
  • iShares U.S. Energy ETF (IYE) - 1,169,697
  • Vanguard Energy ETF (VDE) - 647,095

Reserve currencies offer an excellent way to take long-term crude oil exposure, with the economies of many nations levered closely to their energy resources. U.S. Dollar (USD) crosses with the Columbian 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

Crude oil and energy markets are highly specialized venues, requiring exceptional skill sets to build consistent profits in speculation. 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.

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