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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Traders Should Not Dismiss Momentum In The Oil Market

Traders Should Not Dismiss Momentum In The Oil Market

History may finally be starting to turn in favor of oil investors. Oil has risen rapidly from lows set in February and, while there are never any guarantees, in the past that trend has on average produced future gains in subsequent months. Price momentum occurs in all asset classes, but it is particularly strong in commodities. And that could be a boon for investors.

The idea of price momentum is simple – investments that have done well in recent periods tend to do well in future periods also. The month following a substantial gain in oil prices has tended to be a positive one as well. Oil has risen roughly 13 percent versus early March levels. In the past these circumstances have coincided with an additional 1.5 percent in the month that follows — with the median move in the following month being a 3.7 percent rise. Related: Angola Could Be OPEC’s First Member To Fall

Many investors might dismiss the frequent profitability of momentum across asset classes as being mere luck or a technical phenomenon, but both assumptions would be incorrect. Numerous academic studies have shown that momentum-based trading models can be very lucrative IF they are calibrated correctly. Similarly, momentum is not necessarily a technical phenomenon, instead it likely is driven by behavioral biases and market microstructure explanations.

For instance, Kathy Lien of BK Asset Management commented on a recent CNBC segment for the "Trading Nation" program that the move in oil is a "short-covering rally," and "when you have these types of short-covering rallies, they can oftentimes extend more than you would anticipate, as more traders get panicked about their short trades”. That type of behavioral explanation is consistent with the broader set of research studies that have examined the issue of commodity momentum.

Momentum is a major phenomenon and a driver of various institutional investing strategies which also makes it something of a self-fulfilling prophecy. Since investors expect momentum to hold, they pile into sectors that are experiencing momentum, driving up prices still further. Related: Tesla And Other Tech Giants Scramble For Lithium As Prices Double

Perhaps the best-known institutional investor commodity trading strategy is a trend following one that involves trading in and out of asset classes as they move higher or lower based on data algorithms, and then profiting off of the expected momentum. Unsurprisingly given that, Reuters reported Tuesday that hedge funds have speedily increased their bullish bets on crude oil over the past three months, all the way up to a near-record net long position of 579 million barrels. As more and more funds look to take advantage of the upward increase in oil’s momentum in the second quarter, oil could have further room to run.

None of this changes the fundamentals underlying the oil market – there is still far more oil out there than demand currently supports. But given the lack of new investment in the sector, that situation is only temporary and could have less than a year before the situation is reversed. While supply and demand fundamentals ultimately drive prices, in the short-term it is entirely plausible that the behavioral and trading forces that underlie momentum could arrest oil’s long fall giving the fundamentals time to recover. Only time will tell how the situation plays itself out, but investors should not be surprised if oil prices seem more resilient than one might have expected.

By Michael McDonald of Oilprice.com

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