Crude Oil has been in the spotlight recently given it’s sizeable decline, so it’s time to learn how to deal with Crude Oil as traders. The volatility in Crude Oil makes it a valid trading vehicle (and much less an investment vehicle) because 5 or 10% swings are not uncommon. So in this article we shall explore the main drivers of Crude Oil, it’s volatility characteristics and cyclical influences.
Crude Oil: the Ideal Trading Vehicle?
Crude Oil has been in the spotlight recently, but in reality it is always a decent trading vehicle given it’s volatility. But what makes Crude Oil so volatile anyhow?
- Oil prices are much more volatile than the price of manufactured goods or services that use derivatives of petrolium, due to the lack of flexibility in the supply and demand in the short-term. Think of transportation costs (whether via car, train, aeroplane or ship).
- Volatility is apparent at all time scales from the very short term to the long term.
- Volatility is a key feature of oil markets because the industry is not self-adjusting and has a tendency to go through periods of prosperity and periods of complete collapse (Frankel, 1946). The reason is that Oil is capital intensive with high fixed costs (exploration, production, refining).
- OPEC (and preceeding associations) have not been able to stabilize the price of Crude Oil. This is because they are always backward-looking. For example, Oil investments were held back in the 2000-2008 period due to painful memories of the 1990s slump. But also, there are too many producers with different markets and little information sharing.
All this makes for some great short-to-medium term trading opportunities – if you know how to tame the beast and you have a good grip on money management and trade management.
Our Market Type Indicator is a simple tool that can help filter out the right time to start looking at (or ignore) Crude Oil. Let’s zoom into the recent bull market type and the fall into a bear market type to see just waht kind of opportunities are available to the skilled trader.
Main Drivers of Crude Oil Volatility
Remember, prices move because market participants shift their expectations for the underlying asset and these expectations are based on emerging fundamentals, not charts alone. The main drivers for Crude Oil are:
- Risk Appetite (risk on/off and geopolitical developments or OPEC meetings);
- US Dollar dynamics (since Crude is priced in USD);
- the DOE Weekly Statistics;
- the API statistics;
- the Baker Hughes rig-count.
The following charts will help illustrate how the various drivers influence Crude Oil and to what extent. In normal conditions, general supply/demand dynamics and the USD are the main drivers, so the correlation between EIA/API Inventories and Crude is more evident. Instead, when risk appetite is the driver, the correlation between Crude-VIX-DOW becomes more evident.
Crude vs. DXY (source: TradingView)
Crude vs. Vix (source: TradingView)
Crude vs. Dow (source: TradingView)
A bit of excel work was necessary to illustrate the connection between Inventory data and Crude Oil prices:
Weekly % Change in Inventories (Blue Line) vs. Weekly % Change in Crude Oil (Green Line)
The API Weekly Crude Oil Stock (issued on Tuesday evenings) has become a little more popular recently, but is generally less followed than official EIA data released on Wednesdays. The American Petroleum Institute attempts to anticipate official EIA data and as such has validity.
Source: TMS Europe
The Baker Hughes rig-count has always been influential, but has been dismissed in favour of the DOE statistics. Only recently have market participants started to watch the rig-count and perhaps the reason lies in the release data: Friday evenings. THis means that the effects are not tradable until the following week.
Over to You
Most traders attempt to tackle the markets armed with charts alone. At FXRenew we always try to offer a “chart with a story”. By understanding what is driving sentiment on any given asset, traders are better equipped to understand the odds of an entry on any given day and surely not get caught off-guard by data prints or (in the case of Crude Oil) OPEC meetings.
Finally, for those that are particularily keen on Crude Oil, we have a webinar with a Crude Oil specialist (who has worked at the top 3 Oil trading companies in the world) within our Forex System Development Workshop.
About the Author
Justin Paolini is a Forex trader and member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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