Buying WTI Might Not Be The Slam Dunk You Think

There is, it seems, a constant stream of bad news coming from Iraq. As the rebel forces of ISIS advance closer to the capital Baghdad, it looks increasingly unlikely that there will be a resolution to the conflict that enables the state of Iraq to continue in its current form.

Without wishing to appear heartless about the human tragedy that this entails, my job here is to look at the effects on markets -- and there are, it would seem, likely to be serious consequences for the world's oil market.

Serious supply disruption looks inevitable, which has led many to conclude that positioning themselves long WTI (West Texas Intermediate) crude futures is a certain bet.

If you did so before the news became ubiquitous -- say, back in January when rebel fighters first took control of a city -- then the trade has been a good one.

If, however, you are thinking of doing so now, I would advise caution.

Nearly 20 years in forex dealing rooms around the world taught me many things. I can, for example, swear fluently in multiple languages, and smash a phone handset from a sitting position with one swift blow. From a market perspective though, one of the most important lessons I learned is that news is not the main driver of price, as would seem logical. That title goes to market dynamics and positioning.

Related Article: Investors Love Oil in This Leaderless Nation

Put simply, when the vast majority of players are long, the upside to even the most obvious of trades is limited. Conversely, when the news fades or the situation is resolved, the rush for the exits will be swift and expensive for those who don't see it quickly enough. If we stretch out the time frame of the chart to five years instead of six months, this becomes obvious.

While the upward trend is clear, the corrections back from just below (or in 2011, just above) the $110 level have been pretty steep. This level roughly corresponds to $4/gallon gas in the U.S., and history shows us that that is the level at which oil prices begin to affect the U.S. economy. The big money, which, judging by the last few months of price action is already long, is aware of that and will be looking to take a profit.

It is not that WTI crude can't go any higher -- of course it can. It is just that the closer we get to that $110 level, the harder it will be to climb. Bad news is already priced in. Ultimately, what drives markets is the ratio of sellers to buyers, and right now there are plenty of sellers lurking. It looks like the upside to a long oil trade is limited, at least in the short to medium term, to around 4 percent. If the market turns, however, then $90, or a nearly 15 percent drop, is distinctly possible.

As I said, I learnt many things from my time in dealing rooms and in this situation there is one more that is relevant. If you habitually take trades that offer a 4 percent upside and 15 percent downside you will be out of a job before too long.

By Martin Tillier of Oilprice.com