Top oil trading strategies

Oil is the most widely traded commodity in the world, meaning that a good trading strategy is essential. We look at the top oil trading strategies to employ and go through the basic drivers of the oil price.

Joshua Warner @JoshWarner_IG
Analyst, London

Publication date : 2018-10-31T19:01:33+0000

Source: Bloomberg

Like most commodities, trading oil can seem as simple as weighing up the supply and demand to predict where future prices will head. Falling production and rising demand pushes prices higher, while increasing production twinned with softer economic growth tends to push them lower – but gaining the full picture and understanding what it means at other times (like when output and demand are heading in the same direction) requires a lot of research and some reading in-between the lines.

Brent vs WTI crude oil

There is more than one type of oil being extracted out of the ground, which requires different benchmarks to be used. The key characteristics that separate one type of oil from another include its API gravity (its density compared to water) and how ‘sweet’ or ‘sour’ it is (the amount of sulphur content or impurities, with sweet crude containing less than 0.5%).

Brent and West Texas Intermediate (WTI) are two of the most widely traded oil benchmarks in the world. Brent accounts for oil produced in the UK North Sea (and is named after the Brent discovery made in 1971) while WTI, as the name suggests, refers to the oil being extracted in West Texas and other states including Louisiana and North Dakota. Brent is a heavier oil compared to WTI and although it is still classed as sweet, it does contain higher sulphur levels than WTI. Still, both are ideal for refining into petrol and other products.

Together, they act as global benchmarks for the price of different types of oil produced in various geographies. Brent acts as the benchmark for most of the oil produced in Europe, Africa and some of the Middle East while WTI represents production across North America, particularly US shale.

Today, Brent is the most widespread marker, used as a benchmark price for up to two-thirds of all crude oil traded globally, and demands a slight premium to WTI. However, WTI only demands a lower price because the cost of extracting US shale has dropped considerably relative to the costs of extracting oil from deep underwater in the UK North Sea over the last decade.

What drives oil prices?

At the most basic level oil prices are driven by a combination of supply, demand and speculation – all of which need to play a part in any comprehensive trading strategy. Five basic elements to keep in mind are:

Production/new supply: the amount of new oil being produced
Demand/economic growth: the demand for oil and changes in economic growth
Inventories: the amount of oil that is held in storage
Capacity: changes in capacity of pipelines, refineries and other important oil infrastructure
Speculation: how the futures market prices oil based on future projections and all the considerations above

Oil trading strategies using the futures market

Oil futures are contracts to purchase a certain quantity of oil in the future at a price that is agreed today. The hope of the buyer is that the price they pay is lower than the spot price when the contract ends, while the seller hopes the price they sell for is higher than the spot price. Either way, both have protected themselves.

This means the futures market provides an insight as to where the participants of the futures market – largely oil producers, hedge funds and commodity traders - think the oil price is headed as they are essentially speculating what the oil price will be in the future.

The share prices of oil companies react to movements in the oil price, as this changes the value of the primary assets (the oil) that underpin the business. However, many energy and mining companies use the futures market to try to hedge against potential price falls by locking in prices for future production, which in theory should also help protect them from the swings in the price of oil. Those stocks that don’t participate in the futures market are therefore more exposed to movements in the spot price of oil.

Oil trading using fundamental analysis

All of these drivers can be influenced by an endless list of factors. Production can be hampered by countries being placed under international sanction or could rise if large groups of nations agree to raise output. Weaker gross domestic product (GDP) growth or weaker sales of petrol-powered cars can lower demand. Inventories can dwindle when production declines and rise when companies look to hoard their barrels in the hope of selling them at a later date when prices are higher. Capacity can change if new pipelines are brought on or tighten due to militia attacks or leaks. And the sentiment toward future oil prices can swing from bullish to bearish, or vice-versa, very easily as traders take in and react to the constant stream of data and news flowing from the market.

Although data and reports on the international oil market play a key role in helping us understand the state of play at a global level the most important data is released at a regional level that investors must combine to gain a true picture of where the oil market – and the price – is headed. Saudi Arabia, Russia, the US, Canada and China are among the biggest producing countries in the world and it is important to understand the state of relations between them, as well as the conditions in other important producing regions in the likes of Africa.

Analysing the oil market also goes beyond tracking supply and demand. To predict where oil prices are going over the longer term requires investors to dig deep into other data such as the amount being invested in finding and developing new resources to understand supply over the longer term, or how major shifts such as the one to cleaner energy will weigh on demand over future decades rather than years.

With so much to consider we explain what data oil traders should track and the most important points to take into account when forming an oil trading strategy.

The role of US shale in oil trading strategies

Arguably the biggest change to have occurred in the global oil market over the last decade is in the shift of supply coming from the US. Fracking for shale oil has exploded since 2010: having returned to over ten million barrels per day for the first time since the 1970s, and having sunk to a low of around four million barrels at the time of the financial crisis. That has seen the US move into the top producers in the world and rival Saudi Arabia, which had long used its dominance of the oil market in its political wrangling with western governments. The latest data shows the gap at the top is tight, with Saudi Arabia, Russia and the US having all increased production this year to around 10.5 million barrels per day each. The US, having never exported more than 14,000 barrels of oil per month, is currently exporting a record amount of crude oil – over 66,000 barrels in July 2018 according to the Energy Information Administration (EIA), from below 3000 barrels just five years ago.

US data is therefore a vital tool to use when forming an oil trading strategy:

EIA crude oil stocks change: the EIA measures the change in the number of barrels held in inventory by US companies on a weekly basis. The EIA requires US companies to accurately report their inventory levels. These reports are often compared to expectations: if the rise in inventories if more than expected or a fall is less than anticipated then this is often a sign that demand is weaker than what the market forecast. If inventories rise less than what was expected or decline at a slower rate than forecast then this signals that demand is weaker than what the market expected.
API weekly crude oil stock: the American Petroleum Institute (API) reports the inventory levels of US crude oil, petrol and distillate stocks on a weekly basis, showing how much oil and refined products are being held in US storage. Although the API claims high engagement with the industry, the numbers are provided by companies voluntarily so therefore it is considered less accurate than the data released by the EIA. However, traders use both to gain a more detailed view of the market and so they can spot any large discrepancies between the two.
Baker Hughes US oil rig count: this tracks the number of rigs in operation in the US on a weekly basis and is a vital barometer for the drilling industry and its suppliers. This provides an insight into demand for the equipment used to drill for oil as well as the level of activity taking place. If rig numbers fall then that would imply production in the future will fall, and growing rig numbers suggest production would rise. Baker Hughes also counts rigs in Canada and estimates the level of activity on a global scale. Other firms such as Platts also offer similar readings.

The role of OPEC in oil trading strategies

The Organisation of Petroleum Exporting Countries (OPEC) was set up in 1960 and is a consortium of some of the largest exporters of oil in the world. Modern-day OPEC has 15 member states that collectively account for about 40% of world production, having ceded a share to US drillers over the last decade. The organisation still, however, holds around 60% of the world’s total resources.

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Saudi Arabia has long been the leader, producing anywhere between a quarter and a third of the organisation’s total output. The other members are: Iraq, Iran, Kuwait, Venezuela, Qatar, Libya, United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon, Angola, Equatorial Guinea and the Democratic Republic of Congo. Some countries have left, such as Indonesia, while other members have re-joined after leaving the organisation including Ecuador and Gabon.

Some of the most important reports released by OPEC are:

OPEC monthly report: this report covers major issues affecting the world oil market and provides an outlook for crude oil market developments for the coming year
OPEC annual report: this report contains the performance of individual OPEC members as well as the non-OPEC oil market to provide a comprehensive view of the international state of play. It can also contain an outlook and guidance on future output levels of OPEC nations.
OPEC world oil outlook: this is a long-term outlook considering all the variables that will shape global supply and demand over the next two decades or so. Population and economic growth, the transition to alternative energy sources, investment in exploration, and changes in the refining industry are just some of the topics considered.

OPEC also holds bi-annual meetings when they decide to set production quotas that affect the global supply of oil and its price. This often has seen OPEC work with other major producers that are not OPEC members, specifically Russia, to help form a broader consensus on production.

The relationship between oil prices and the US dollar

Oil and other commodities are largely traded in US dollars (as the reserve currency of the world), meaning movements in the foreign exchange market play their role in steering the price of oil. The general (but far from perfect) rule is that the two have an inverse relationship: oil prices fall when the dollar gains against other currencies and vice-versa. Countries using other currencies have increased buying power when the dollar weakens and lessened when it rises, influencing demand for oil and other commodities as buyers look to get the best price possible.

The performance of the dollar is, however, just one of many drivers of the oil price, so other factors can override what’s happening in the forex market.

Learn more about forex trading

How geopolitics can impact oil prices

The vital role it plays in the world means those rich in oil have often used this commodity as a tool in foreign affairs, and many countries import oil and other energy sources from countries that they might otherwise have very little to do with. Plus, like many metals, a lot of the world’s oil lies in unstable territories where supplies are unreliable, such as in Nigeria where companies like Shell have been plagued by militia attacking pipelines and other vital infrastructure.

For example, frosty tensions and international sanctions have not stopped Europe importing huge amounts of oil, gas and other energy products from Russia – the Netherlands was the second biggest importer of Russian crude in 2016, accounting for 15% of total exports (behind China at 20%), followed by Germany at 10% and Poland at 7.1%. Italy, Spain, France, Sweden and the UK all import oil from Russia. Additionally, 15% of Saudi Arabia’s crude exports (accounting for about two-thirds of the country’s total exports) go to the US, despite often clashing on human rights and on how to handle wider issues in the Middle East. Even today, with US President Donald Trump and Chinese President Xi Jinping locked in a full-scale trade war, the US is now exporting over 20,000 barrels to China each month. At the end of 2016, before Trump entered the White House, the US was exporting just 6600 barrels to China each month. And Trump has often tried to tell Saudi Arabia how much oil to produce so US shale drillers – those that have stolen market share from the House of Saud – can be profitable. There is a lot of tit for tat between the US and Saudi Arabia: they both want oil prices to be as high as possible to maximise profits but low enough to make it an unprofitable business for the other.

The point of these examples is to highlight the importance of oil and why it is so sensitive to political relations across the world: the US, Russia and Saudi Arabia account for over one-third of worldwide oil production and almost 30% of total exports. Other major producers are not free from political strife, whether it be at home or abroad, with countries including Iran and Iraq among the largest producers and exporters outside of the top three. The sanctions slapped on Iran and Venezuela by the US and the subsequent pressure Trump has placed on other nations not to purchase their oil is another example of how geopolitics can shape oil prices.

Oil trading: other data and reports to track

There is an endless list of resources available to help form an oil trading strategy but some other notable sources include:

International Energy Agency (IEA): the IEA releases a number of reports to help oil traders, including a market report forecasting future supply, demand and prices. The IEA also releases an annual report that provides a more detailed and historical perspective of trends in the global oil market.
Big Oil outlook reports: a number of the biggest oil companies release detailed reports predicting what the future has in store for the market. BP’s Energy Outlook is one of the most highly regarded and widely used reports. There is also ExxonMobil’s Outlook for Energy and other useful tools on offer such as Royal Dutch Shell’s Global Energy Resource Database.
European Commission energy data: the European Commission offers a range of data and analysis on the EU energy market, including a weekly oil bulletin, crude oil imports and supply cost and market analysis of energy prices

Oil trading using technical analysis

The technical indicators used to analyse oil prices are the same as those applied to other markets such as forex or equities. Some of the most popular indicators used are outlined below:

Moving averages: the moving average aims to smooth out historic price data, calculating the average price over a certain period of time. For example, the 20-day moving average is the average rate over 20 days, and is recalculated each day. On day 21, the first day is dropped from the calculation. This allows traders to look how the current rate compares to the average, which will filter out any sudden or unexplained movements that could distort the historic price data.
Moving average convergence divergence (MACD): this takes the moving average over a short timeframe and an average over a longer timeframe. Traders look for when the short-term moving average crosses over with the long-term average. If the short-term moving average surpasses the longer-term average then it generally suggests that prices are heading higher.
Relative strength index (RSI): this index is an indicator of momentum that compares the average gain made when prices have risen over a set period of time, for 14 days as an example, compared to the average losses made in the same period. This provides an idea of whether gold is set to become overvalued or undervalued in the near future.
Stochastics: the stochastic oscillator also helps gauge the momentum behind the price. The theory behind stochastics is that prices that have been trading in an uptrend throughout the day usually settle at the upper end of that day’s price range, and those experiencing a downtrend will close the day at the lower end of the range. Operating within a range of zero to 100, a reading below 20 signals an oversold market while one above 80 shows signs of a market that is overbought. This is often used in conjunction with the RSI.
Average true range (ATR): ATR measures the volatility of a trend but does not identify trends itself. ATR is a type of moving average that compares the highs and lows of gold over a set period of time, with the most recent closing price producing the ‘true range’ for the five most recent trading days, which is then averaged out to produce the ATR.
Bollinger bands: this is a helpful analysis to identify when sentiment and prices will change direction within a range-bound market. Bollinger bands identify three important levels that put the current price into perspective: the trendline (where it is heading now), the upper line (where resistance will be met), and the lower line (where support will kick in). These three levels provide a range in which to trade in to help signal where the turning points are.
Pivot points: tools like the Fibonnaci retracement and Elliot wave help identify pivot points - the price likely to spark a change of sentiment in the market – and the levels of support and resistance

Oil trading: long straddle

Some popular strategies revolve around trading volatility in oil prices. If current volatility – measured by the likes of the Cboe Crude Oil ETF Volatility Index, which tracks WTI – is greater than historic volatility, then this is regarded as a signal that this volatility will continue to increase going forward. If volatility is currently lower then the price then stability should increase.

One strategy used to profit from increased volatility is called the long straddle, which involves buying both a call and put option at the same strike price so traders can profit whether the price moves higher or lower. The important thing when using a long straddle is that it moves because there is volatility. A short straddle, on the other hand, only pays off when the price doesn’t experience severe volatility and involves selling matching call and put options. Again, this is speculating on future volatility rather than what direction oil prices will head in the future.

Oil trading: bear call spread strategy and bull call spread strategy

The bear call spread strategy involves selling an out of the money call or put and buying another out of the money call or put, while the bull call spread strategy involves buying an out of money call or put and selling another. The difference in strike prices of the two call or put options is what provides the profit for traders.

Out of the money refers to an underlying asset’s price in relation to the price at which it can be bought or sold, known as its strike price. As well as being out of the money, an option can be in the money or at the money. Together, these terms are known as an option’s ‘moneyness’.

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