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It Could Be Time to Trade the Energy Market

It Could Be Time to Trade the Energy Market

Oil is, historically, one of the most volatile markets. This makes it attractive to short term traders. Volatility is the factor that leads to large price moves in short periods of time. Being on the right side of those price moves is important to short term traders.

The CBOE Crude Oil ETF Volatility Index ($OVX) offers one way to compare the volatility of oil to the volatility of other markets. This indicator stands at about 28 while the more widely followed VIX index, a measure of stock market volatility, is near 11. By this measure, oil is more than 2.5 times more volatile that oil.

Volatility is one factor traders consider. The other important factor to consider is trend. Oil appears to be in a relatively narrow range with a slight upward bias to the direction of the short term trend.

Fundamentals Are Bullish for Oil

When considering fundamentals for oil, OPEC must be reviewed. OPEC is the cartel of oil producing countries, largely in the Middle East. It includes some of the world’s largest suppliers and OPEC has been attempting to limit supply for most of the past two years.

OPEC’s forecasts and actions are relatively bullish.

OPEC recently raised its 2017 economic growth forecast for the world to 3.5% from 3.4%, with 2018 remaining unchanged at 3.4%. Growth forecasts for India have been lowered 0.1% in 2017 to 6.7% with 2018 unchanged at 7.5%. China’s forecasts remain unchanged at 6.7% in 2017 and 6.3% in 2018. Growth is expected to be 0.5% and 1.5% in Brazil and Russia, respectively.

Based on increased economic growth, world oil demand forecasts have seen an increase of 50,000 barrels per day and are expected to rise 1.42 million barrels per day in 2017, up from 1.37 million barrels per day. 2018 demand has also been revised upwards by 70,000 barrels per day to 1.42 million barrels per day.

These upward revisions bring world demand to 97.91 million barrels per day in 2017 and 99.12 million barrels per day in 2018, with the increases being driven by growth expectations in China and Europe.

Non-OPEC production growth forecasts remained unchanged in the most recent forecast at 0.78 million barrels per day and are now expected to average 57.8 million barrels per day in 2017.

An increase in demand is bullish. The supply side of the forecast is also reasonably bullish.

OPEC production in August decreased 79,000 barrels per day, averaging 32.76 million barrels per day; primarily driven by a 0.12 million barrel per day decrease in daily output from Libya. Libya’s largest oilfield was shut-in due to unrest and that the nation is not subject to OPEC production quotas at the present time.

OPEC countries have been meeting those quotas in recent months, demonstrating a discipline that few analysts expected to see in the long run.

Forecast demand for OPEC production in 2017 has increased by 0.3 million barrels per day since last month. Total demand for OPEC crude this year is now seen to be around 32.7 million barrels per day, implying a slight amount of oversupply in the market of just about 10,000 barrels per day.

Finding a Trade in Oil

With the fundamentals supporting higher prices, the question for traders is which vehicle to use. When looking at commodities, some investors trade shares of companies involved with that commodity. For oil, they might look at the exploration and production companies.

This approach made sense years ago, before exchange traded products were available on specific commodities. These products, formally exchange traded notes or ETNs, have been introduced on an increasing number of commodities in the past few years.

ETNs often have deep liquidity which makes them easy to trade. They directly track their underlying commodity which makes them the ideal choice for investors seeking exposure to a specific commodity. But, there is a significant disadvantage associated with ETNs when it comes to taxes.

Many of these instruments require the filing of separate tax forms. Investors receive a K-1, which is a more complex form than they receive for stocks or options trades. These forms are often delivered late in tax season, causing delays in filing or forcing the filing of amended returns if investors don’t realize they will be receiving the document.

Using options, even simple options trading basics strategies like buying calls or puts, can avoid this problem. Trades in the options contracts will be reported just like other trades and no special tax forms should be required.

For oil, The United States Oil Fund LP (NYSE: USO) is an exchange-traded security designed to track the daily price movements of West Texas Intermediate light, sweet crude oil.

The investment objective of USO is for the daily changes in percentage terms of its shares’ net asset value to reflect the daily changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in price of USO’s Benchmark Oil Futures Contract, less USO’s expenses.

USO’s Benchmark is the near month crude oil futures contract traded on the New York Mercantile Exchange. If the near month futures contract is within two weeks of expiration, the Benchmark will be the next month contract to expire.

USO invests primarily in listed crude oil futures contracts and other oil-related futures contracts, and may invest in forwards and swap contracts. These investments will be collateralized by cash, cash equivalents, and US government obligations with remaining maturities of two years or less.

An investment in USO is close to a direct investment in the commodity contract. Buying a call will allow participation in higher oil prices.

A Specific Trading Strategy

USO is a low-priced ETN, trading near $10, about one-fifth the price of a barrel of oil although that is not a fixed ratio. It’s daily percentage change is generally in line with the daily percentage of the price of oil. This means USO can be used as a leveraged trade in oil.

covered call options increase the leverage. Although weekly options are available, at current prices there is not much time premium in the longer dated options. That makes the October monthly options expiring on October 20 attractive.

The October 20 $10 call in USO is trading at about $0.35. This option will be profitable assuming oil makes a 6% move over the next five weeks.

The average true range (ATR) indicator can be used to determine the average price move of the ETN.

The ATR is simply an average of the true range (TR) and the TR is an indicator developed to correct a problem with the range calculation.

A stock’s price range is defined as the difference below the high and low price for a day. This calculation works fine most of the time but if a stock gaps up or down at the open, the range calculation will miss the volatility at the open. The TR corrects that problem.

The TR is the largest value of three values that need to be calculated each day. Those values are the current high minus the current low; the absolute value of the current high less the previous close; or the absolute value of the current low less the previous close. This includes the effect of gaps.

The ATR is a moving average (MA) of the TR. ATR measures volatility. It will increase in value when the stock’s price moves are larger than they have been in the recent past. ATR will decline in value when a stock’s volatility declines and the values of the TRs become smaller.

USO’s ATR is about 14%. This indicates there is a high likelihood of a 6% move in the ETN. A 14% move in the ETN could push USO above $11 and deliver a gain of more than 180%.

USO could be the best way to trade oil for individual investors. The options are relatively inexpensive and the potential rewards are significant.