Commodity price, Energy crisis, Hedging, Market research, Market trends, Oil market, trend following

5/5: $500 oil and how to manage the looming uncertainty and risk

Let us recap what we covered in parts 1, 2, 3 and 4 of this report. In spite of the low price of oil (just below $50 at the time of this writing) and predominantly bearish market sentiment, the “big picture” suggests that we are facing a grave energy predicament. Petroleum producing countries, especially members of OPEC, have been vastly overstating their oil reserves. Production of oil from conventional sources is in an irreversible decline. Over the next 15 years, the EIA projected that production will fall over 40% short of demand. New drilling technologies, and this includes fracking, are unlikely to impact this shortfall in a meaningful way.  These conditions have led the UK’s Ministry of Defence to predict in 2012 that oil price could rise to as high as $500 per barrel over the next three decades, causing crises of unforeseeable proportions. For the oil market participants, the trillion dollar question is how to cope with the looming uncertainty and risks.

Here I will propose an elegant solution to this problem, but I must first make a confession: the present report is an updated version of the report I wrote in January 2015 when oil price fluctuated essentially where it is now (in the mid to high 40s). But, instead of shooting higher in accordance with the bullish fundamentals I outlined here, it almost halved, reaching the low of $27/bbl this year. While I remain fully convinced that my analysis is correct and that we are likely to see much higher oil prices in the future, had I traded according to this conviction, I would have taken long exposure to the price of oil, sustaining devastating losses.

You see, in financial markets, doing your market analysis diligently and being right does not always pay off. Markets aren’t moved by the fundamentals, but by the way participants in the aggregate interpret market conditions. In other words, the moving factor is human psychology, not the objective reality. Driven by human psychology, the price discovery process often generates trends or even bubbles, as well as unexpected price collapses. Whether the market is “right” or “wrong” is irrelevant – all that matters to a market participant is whether he or she gained advantage or loss from the unfolding price events.

If there is one thing I have learned over these 20+ years trading commodities, it is to follow trends regardless of my own personal conviction. Using the trend following model I designed, I formulated a set of trend following strategies adapted for long-term, short-term and medium-term trends. This enabled us to generate decent profits on our allocations to energy markets as the following three charts illustrate:

StrategyPerformance_WTI_2014to2016

The curve on top is the price curve, while the colorful set of curves in the sub-chart indicates my strategies performance in the WTI futures market (NYMEX Light Crude Oil).

StrategyPerformance_GasOil_2014to2016

StrategyPerformance_RBOB_2014to2016

Research shows that a large majority of investors, traders and industry hedgers rely on the analysis of market fundamentals and near-term forecasts in guiding their trading decisions. For a number of important reasons, this approach has significant shortcomings. Applying instead systematic trend following techniques should prove far more effective and sustainable. If the UK Ministry of Defence’s forecast of $500 barrel of oil comes to pass, the price change won’t happen overnight. Major price events almost always unfold as trends and trend following should keep you on the right side of the coming changes. Should you or your organization require further advice in this sense, do not hesitate to reach out and contact me.

Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.

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