Is Going Long Oil a Reliable Enough Play Right Now?

Oil

Energy analyst Joe McMonagle, former chief of staff at the Department of Energy, expects oil prices to rise over the next few months. Is this belief reliable enough to bet on?

While both investing and trading both place bets on the direction of a security, this doesn’t mean that we can just put our money down on a whim, blow on our hands, and roll the dice. We are faced with considerable uncertainty when we trade or invest, and there are no sure things, but this does not mean that we want to be lax and just throw our money around on hunches or in situations where there may be better things to bet on and especially when the odds we get just aren’t favorable enough.

Betting on the price of oil going up or down is something that a lot of traders do, and some make a whole lot of money doing it. There is also a lot of people who bet on oil futures and don’t tend to do all that well, and the futures market is a lot like a poker game, where the money flows from the bad players to the better ones.

Those who don’t do this for a living and have a proven record of successfully trading oil or whatever other asset that they may trade in the futures market have to be especially careful. When we read recommendations in the media that suggest that people take a position, and the article is clearly aimed at amateurs, we need to be very careful with acting on these recommendations lest we just donate money to the better players.

If you pick your spots, like for instance going long oil around the first of the year when stocks were clearly rebounding, and held your position until things topped off and started to reverse in April, you could have made a lot of money. You could have made even more riding the wave down over the final quarter of 2018, when stocks tanked as well, although the amount that could have been made with oil futures is up to 12 times higher, turning moves of 20% each way into over 200% each way.

You don’t have to use the full leverage of course, and it only makes sense to if you really know what you are doing and are capable of managing the risk, which involves staying in and letting your profits run if you end up right and getting out quickly if you are wrong.

Making a big mistake with high amounts of leverage not only can involve you losing all of the money in your trading account, it can have you owing your broker money on top of this. This does not mean that people should just be afraid and say no to this, but they need to be afraid indeed about leveraging positions beyond their level of skill and risk tolerance.

You can set whatever leverage you want with futures, including even de-leveraging them, where you can just back your position with more than 100% in cash, with 200% for instance where you only capture half of the gains and losses, although this doesn’t really make a lot of sense. These things don’t move enough without leverage, so you need a certain amount, and if you cannot handle this, you should not be trading it.

They even have ETFs now that track oil prices, and while this does allow people to take positions in oil with no leverage, even oil doesn’t move enough to compare favorably with a good stock. Stocks both move in a more predictable fashion and also tend to move up a lot more than oil does over time, such that investing in oil is simply a stupid idea. This does not keep some people from trying to do it though, just like they invest in other commodities straight up such as precious metals, which makes even less sense if anything.

Trading Anything Requires We Rely on Actual Positive Expectation

What we want to do instead with oil is to look to capture predictable moves in it, where we’re in while the going is good and out when it turns around. You can trade oil on anything from weekly bars to tick by tick charts, but this all involves trading, and successful trading never involves just guessing at things like Iran attacking Saudi Arabian oil fields like they did earlier this year.

Some people still like to do such things though, the gamblers, where you put some money down on the possibility of more attacks and then sit back and hope that your number comes up. Senior energy analyst Joe McMonagle of Hedgeye Risk Management is one of those people who likes to gamble this way, and he’s suggesting we join him.

This is an absolutely terrible way to trade, and the reason is that trading is a game of probabilities, not taking larks on something like this. Perhaps going long oil here makes sense in its own right such that this prospect becomes a nice bonus, but you don’t make money on outlier events over time and this causes you to trade blindly in fact.

Blind traders in particular get crushed, and while we might get lucky once in a while, over time we’re going to be unlucky most of the time, and being unlucky here means losing a bunch of money overall. We can manage the risk by going small, like with an ETF, but these guesses just don’t pay off enough, and our expected value here will at best be paltry.

During the last attack, this did cause a spike in oil prices as we may expect, but the fun didn’t last long and within hours of the time the news of this hit, it was over and it was actually time to fade the move. Those that did made some real money as the situation was dealt with by the Saudis and oil prices fell for two weeks straight and gave back all the gains from this and then some.

Even if you were holding the winning ticket here, you could have lost money if you didn’t get out quickly like the smart money did and reversed. The runup could not have been predicted, but the selloff after it happened sure could, and we even commented at the time that being short here was a fabulous opportunity, and it ended up even exceeding our expectations. The trade needs to speak for itself though and it will tell you when it is done. Riding it down until we found a new bottom was a very easy trade as well, and this is how you make money from the things.

The primary market participants, those who trade in real oil and don’t just trade the contracts, tend to really panic after such a thing and pay way too much, and then sit back and watch the traders eat their lunch. Traders aren’t exposed to any outside risk beyond their trades, where producers and consumers of oil have to worry about how movements in these contracts are going to affect them ultimately, and that’s a big advantage if you are good, but sure isn’t if you don’t know what you are doing.

Barron’s is crowing about how well oil has done this year, but trading is a whole lot different than investing, where a 15% gain year to date isn’t meaningful unless it is straight up and can be held for that long, like the December to April move was. We were actually up around 25% year to date back in April and have given a good part of this back since. You have to look at the current move when trading oil and what happened in the first quarter on a different move, with several in both directions since, is just not relevant.

You Can’t Rely on Guessing if You Expect to Succeed at Trading Oil

Being down 10% over the last 7 months is not indicative at all of any bullishness, and even looking at year to date numbers doesn’t make sense for oil traders, as too much of this is too far in the past to matter.

They also mention our wanting to take advantage of this hope of another attack that McMonagle is basing his speculation on, by buying an ETF to do it, but for the same reasons that oil isn’t something we want to invest in, oil ETFs certainly aren’t either. On the timeframe that people who buy oil ETFs use, it is unpredictable and unreliable and does not produce much potential for good returns either, competitive returns such as people get with stocks.

OPEC is also mentioned as another reason why oil may go up soon, but OPEC isn’t what it used to be and they don’t have a lot of power anymore. They can cut production as they wish, but they can only afford to do so much and other major producers such as the U.S. and Russia will just step in and fill the gap.

OPEC is actually bearish on oil for 2020, and have forecasted both falling demand and increasing production, which both put the price of oil down. We don’t want to ever be trading these things either, because this is all just speculation and you make money trading oil when the show is underway, not from previews.

People just need to say no to oil ETFs, and if they really want to get in on the excitement of trading oil, and there’s plenty of excitement doing this indeed, they need to trade oil with at least some leverage to elevate oil over stocks. If we want to pull this off, we need to learn how to follow trends, not guess at the future, because trends deliver a lot more certainty than guessing does.

The problem with just guessing is that you not only have to guess right, the timing of your guess also needs to be right, and this is where the idea falls flat on its face. We might believe that oil will go up by $10 a barrel over the next few months, but we also need to know what path we may expect it to take to get there, as well as when this actually will happen.

The only good way to do this is to follow the price of oil, which tells us where the market is headed, and the market decides the price. A lot of amateur commodity traders think that the task is to just guess and hope you outguess the professional guessers, where good traders punish both by taking their money.

This is not at all like stocks, which can just keep going up and up and make money for all investors. When money is made with oil futures, this gain must be paid by others, and you do not want to be among them. There is a winner and loser with every trade with commodities and people only get rich by winning these amounts from other participants.

As it turns out, oil is actually in a bit of an uptrend since the post-attack selloff ended in early October. It’s only up about $3 a barrel on this ride though, but with leverage, $3 a barrel can be pretty exciting, where with an ETF, it’s not all that meaningful. This would also require that we hit this right at the bottom, and while this was an easy bottom to spot for a good trader, just the fact that you trade oil ETFs makes it quite likely that your trading skills are subpar, because you’d likely be trading the futures contracts yourself if you were any good.

For the rest, hopefully the entertainment value received makes up for whatever amount they may lose. This does not mean that they all lose, but oil trading either exposes you to too much volatility if you look to hold longer or even medium term, and the much greater number of trades when trading in the short term will really expose trading weaknesses.

Oil is only second to cryptocurrencies in terms of unpredictability, and this is something that we really want to pick our spots with when we trade it. There are some things like stock index futures where you can be in the market full time on one side or the other if you want, but oil is nothing like that and requires that it particularly behave in a manner that is predictable enough.

It’s really not predictable enough right now to want to be in on either side, even if using some money that you can play around with and afford to lose with little impact on your overall portfolio. If you really want to mess around, there are just better things to play with right now.

If you are an amateur trader who likes to gamble though, and go long oil right now with no other controls other than hoping that it will be higher in February, you are so out your element in this game that it is even comical. This isn’t even a checker player trying to play chess, it’s one that moves their pieces with their feet with their back turned to the board. You won’t win many games this way.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.