So you want to make money on an oil trade. The way the price of oil is moving at the moment, you'll have an opportunity to get in and out for massive profits. On the other hand, if you’re incorrect, your scheme could go up in flames.
Don’t you wish you knew which way oil was going to next? While nobody knows that answer for certain, you can greatly increase your odds of success by using logic. In this case, we’ll take a look at VelocityShares 3x Long Crude Oil ETN (UWTI).
The first thing you should know is that a leveraged exchange-traded note (ETN) uses financial derivatives and debt to amplify the returns of an underlying index. These are high-risk trades that should be seen as just that: trades. They should not be approached as investments. For instance, over the past three months, UWTI has depreciated 74.04%. Since the key to the game is capital preservation, this type of trade must be avoided. That said, during the same time frame, VelocityShares 3x Inverse Crude Oil ETN (DWTI), has appreciated 192.19%. If you’re going to jump in on either side of this trade, then you need to know the facts.
Unfortunately, the problem with trading ETN's and exchange-traded funds (ETF) (aside from fees) is that the market can remain irrational longer than you can stay solvent. In other words, even if you’re correct, logic might take a while to play out. Keep that in mind as we move forward. (For more, see: How Oil ETFs React to Falling Energy Prices.)
Speaking of logic, the primary reason for the drop in oil is global deflation. And there’s one thing investors and traders need to remember: You can’t stop deflation. You can offer a free money policy and come up with all types of creative ways to “keep the economy going,” but in the end, deflation will win. The Federal Reserve, as well as other powers, have no interest in seeing deflation rear its ugly head on their watches. Arguably, it’s about legacy, not what’s best for the country over the long haul. This all relates to the price of oil. Here’s why. (For more, see: What Determines Oil Prices.)
It’s beginning to appear that Federal Reserve policy has created numerous bubbles. And just like all deflationary environments, the first area to show cracks is commodities. Global demand for oil has declined and supply has increased. That being the case, it wouldn’t take a Mensa member to figure out that the price of oil should continue its decline.
If the economy had to stand on its own two feet right now — without the help of the Federal Reserve — it would need a very sturdy cane to help it creep forward. If you have doubts about that, ask yourself the following question: “If the economy is truly healthy, why is an easy money policy still in place?”
Anyone who pays attention knows this, and if you’re reading this article, then you’re paying attention. But the vast majority of the public isn’t paying attention, instead going with the popular opinion that lower oil (and gasoline) prices relate to an election year. This is a ridiculous assessment with no historical accuracy. (For more, see: OPEC's Decision Sends Stocks Lower.)
Reduced Demand, Geopolitics
The ultimate point here is that reduced global demand has led to a deflationary environment. When demand is low, prices must move lower so consumers will continue to purchase products and services. The first hint of an upcoming deflationary environment is often in commodities, just as it was in late 2008. For example, in July 2008, crude oil traded at $145/barrel. On Dec. 23, 2008, it traded at $30.28/barrel. In early 2009, we were in a deflationary environment. This is bad news for oil in today’s world, and oil is likely to hit $30/barrel before it hits $100/barrel.
Another big hint is geopolitical tensions, which relates to a weakening global economy. Russia is a good example. These rising tensions are another sign that the global economy is weakening, not strengthening. Remember, everyone is happy when they’re making money.
Deflation is likely to spread in Europe first. Italy is already there. And the entire Eurozone saw annual inflation of just 0.3% in November — a five-year low. Oil will likely continue to go lower, which makes UWTI less attractive. (For more, see: Oil and Gas Industry Primer.)
The Good News
The one catch here related to deflation is that it’s a good thing, not a bad thing. Yes, it will be exceptionally painful for many years, but that’s the only way out. The only way to grow organically again is to pay off debts and for prices to come down so businesses can innovate more and real estate can become affordable for the average individual/family. This is how wealth will be created again in America … many years from now. (For more, see: The Upside of Deflation.)
The Bottom Line
If you’re going to initiate any position in UWTI, then it should be in and out on a dead cat bounce. But this is nearly impossible to time and extremely risky. There are much better trading and investing opportunities available at this time. Please do your own research prior to making any investment/trading decisions. (For more, see: The Dead Cat Bounce: A Bear in Bull's Clothing?)
Dan Moskowitz doesn't own shares of UWTI.