Oil Prices Are Predictable During Cycles Of Fear And War

| About: iPath S&P (OIL)

"Oil is like a wild animal. Whoever captures it has it."
~John Paul Getty

In looking through a sentiment charts on oil (NYSEARCA:OIL), we noticed an interesting pattern around several of the war and conflict-related oil price highs of the past decade. From the U.S. invasion of Iraq in 2003 to the air war against Muammar Gaddafi in spring 2011 to the Iranian-Israeli tensions over Iran's nuclear program in early 2012, we've seen the oil price (OIL, CRUD, BARL, OLO) repeatedly driven high by conflict in oil-producing nations.

In the following chart, you can see the spike in oil prices around the NATO air war on Libya.

More recently we see the same pattern around U.S. and Israeli threats to forcibly dismantle Iran's nuclear program. See the chart below:

Having seen such patterns in this data, we decided to run a statistical study to establish if there is statistical significance - and trading opportunities - based on these patterns.


"The international energy market is dependent upon reliable transport. The blockage of a chokepoint, even temporarily, can lead to substantial increases in total energy costs."

~ U.S. Energy Information Administration, August 22, 2012.

Academic research shows that a small probability of an emotional event occurring - such as an oil supply shock or a military assault - are over-weighted in human probability assessments. As a result of this overweighting, humans overreact to even the mention of possible vivid, negative events. So when fear is high, odds are that investors are overreacting to some vivid negative event, and prices are likely to revert to their pre-crisis level once fear begins to wane.

We ran a series of simple data mining experiments to sort out how Conflict, Violence, and Fear have predicted oil prices over the past 14 years. If you've got an aversion to data-mining, then you'll have lots of bones to pick with our analysis, but in our experience oil investors find these results illuminating. This is not a formal back-tested study, but rather we fit our data to the entire historical 14-year period to see if we could glean useful insights.


We know from experience and research that sentiment and news are nonlinear - that is, important information hits the markets in bursts and is typically only significant at high levels.

Using the Thomson Reuters MarketPsych Indices (TRMI) as independent variables, and changes in the highest-volume futures contract of West Texas Intermediate Crude (like CRUD) as our dependent variables, we investigated how different intensities of the TRMI's Fear, Conflict and Violence impacted oil prices. Using TRMI data up to the day's futures market close, we then forecasted the price from the following day's open price to the open price one month in the future. We tested 14 years of TRMI Crude Oil sentiment data.

In our sentiment data, Conflict refers to high levels of dispute and disagreement surrounding the oil markets. Violence refers to military threats and actions associated with the oil market. Fear is a measure of references to "worries," "concerns," and other symptoms of anxiety surrounding oil prices.


After analyzing our data, we saw an interesting story emerge. First of all, when the news of a conflict or potential war hits the market, it does of course cause a spike in prices. Importantly for traders, that spike has momentum - oil prices continue higher for the following month.

For example a one week spikes in Violence (91 times in the past 14 years, 2.2% average following month return) and Conflict (94 times, 3.2% average future one-month return) lead to high returns. Amazingly, these "spikes" are only changes above average, and as a result cover half of all sampled months. We see a similar positive momentum effect for Fear, but only at high levels of change, probably because Fear is a relatively sparse variable. A rise in one week fear greater than 90% of all such spikes happens 19 times with average 3.2% monthly returns.

When we look at two variables together such as when Conflict rises AND ProductionVolume drops, the following month shows an average return of 8.2% (28 occurrences, 82% accuracy). This is an important result because it is predictive and it is common and it explains what drives prices higher - both conflict AND concerns about declining production. Oil traders have time to enter into these positions.

So we can see above that rising Conflict, Violence, and Fear stimulate further price rises, and these price increases are predictable. It appears that oil traders take their sweet time positioning themselves when tensions rise. This reinforces a personality test finding that speedy reaction time is one of the key traits of top traders.


Despite seeing increases in Fear, Violence, and Conflict driving prices higher, static high levels of these sentiments actually precede price declines.

When the 3-month average of Fear is in the top 20% of its historical range, the Crude Oil price drops an average of -1.8% over the next month (37 samples). For Conflict in the top 20% of its historical range, the drop is -3.2% over the next month (37 samples).

When we again look at Conflict paired with another variable (an Association Rule), we find that high average levels of Conflict paired with a sudden one-week drop in Urgency precedes an average -5.5% (19 samples) drop in the crude price over the next month. When Urgency declines (the crisis ends), paired with high average 3-month levels of Conflict, there is a predictable opportunity to short oil and profit.


"Iran's and Syria's defense ministers threatened on Friday to unleash attacks on Israel if Mr. Assad was in danger."
~ New York Times, August 30, 2013

The Syrian use of chemical weapons and the potential for Western involvement in the Syrian civil war are putting oil markets on edge. Our latest oil Conflict, Fear and Violence data series can be seen in the following chart:

This chart shows that tensions have been gradually rising, alongside the oil price, since May 2013. The chart demonstrates what our data research told us - price momentum in oil is driven by the conflict and the expectation of production-disrupting war.


OIL: Our one-week oil price outlook is down (CRUD, DBO, OIL, OILZ, OLEM, OLO, TWTI, USL, USO,BARL, OLO) especially given the drop in Urgency as the U.S. Congress debates an assault on Syria. We'll see how the assault plans evolve, but for now the Urgency is down and crude prices are likely to drop over the next week or two. I wouldn't go long-term short oil until we see the Fear and Conflict sentiments stabilize, and Violence start to fall.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.