It is hard to escape the feeling that, at some point, oil will bounce back. The dramatic yet sustained decline in WTI suggests to those familiar with markets that when that bounce comes it will be quite rapid. The assumption is that there are enough long term short positions that an upward move will be exaggerated. That may be true, but fundamental supply and demand always trumps technical or market positioning factors in the long term, and those figures suggest that we are not at that point yet. The latest IEA numbers indicate that in the fourth quarter of last year oil supply decreased from Q3 slightly, but still exceeded demand by 390,000 barrels per day, and that doesn’t include the Iranian oil that hit the world market this month.
As long as that disparity between short term technical influences and long term fundamentals exists there will not be a sustained recovery in price. What there will be, however, is volatility. Yesterday (Thursday), the reaction to the inventory numbers for U.S. oil demonstrated how that can lead to illogical market moves. The build in inventories of 4 million barrels was significantly more than the 2.4 million original estimate and the report also indicated that U.S. production had barely moved, remaining around 9.2 million barrels a day. Logically that should have prompted another move down, but instead we saw one of the biggest one day gains for months. That move has been attributed to a “could have been worse” reaction among traders following the API estimate of a 4.6 million barrel build, but it demonstrates that positioning and sentiment can force vicious, counterintuitive, and essentially unsustainable moves on the market.
Those conditions are great for trading oil, but, to many retail investors, “trading” is a scary word. It doesn’t need to be, however. If you understand that taking occasional small losses is a part of trading and have the discipline to keep those losses small then venturing into the world of trading can provide profits while you wait for the supply situation in oil to reach the point where a recovery is inevitable. There are several ways to approach trading in this context.
Most people, when they think of trading oil, immediately thing of futures. That is what we hear about all the time and it is the preferred instrument for experienced traders. However leverage, the very thing that makes futures appealing to traders, is what, often rightly, scares those new to the idea. A one contract position in the NYMEX oil futures market (CL) equates to a profit or loss of $10 for every 1 cent move in the price and requires $4400 in margin. Just a 44 cent move in WTI, therefore, can cost you 10 percent of your initial investment. In a market that has jumped over 300 points in the last couple of days, for example, that can quickly lead to huge losses. Futures are really only for those with a lot of risk capital and who know what they are doing. You can halve the risk by using the NYMEX Mini contract (QM) but that is still too much for most people and requires a futures trading account, something that most retail investors don’t have.
A better solution for most is to use leveraged oil ETFs, providing that they understand the nature of those instruments and the specific risks attached to them. The 3x leveraged long oil ETF UWTI and the equivalent short ETF DWTI can be used to trade your view of oil, whatever the direction. They are generally available in brokerage accounts, although most firms will require you to sign a waiver saying that you understand the risks involved in them.
The first thing that must be said here is that these instruments are only suitable for short term trading. The effects of contango and the constant rolling over of contracts eats away at the long term value of the funds, making them unsuitable for holding long term. In addition, while not as leveraged as a futures play, these ETFs will move roughly three times as much as the oil price on which they are based, which makes discipline essential if you are to use them. Setting and sticking to a stop loss level is a pre-requisite.
The way it looks, oil is going to stay volatile at around these levels for a while. That makes picking a long term bottom an almost impossible task; there is just too much chance that you will be squeezed out at some point. It doesn’t mean, however, that you have to sit idly by. Investors can trade those volatile moves via leveraged ETFs, and if that is done in a controlled and disciplined way, it can provide a return, even in an essentially directionless market.