Is Now the Time to Sell Oil?

| About: VanEck Vectors (OIH)

My wife and I just had a baby boy on May 8, so I'll be taking a short break. I've asked Andy Crowder, a seasoned technical analyst and options trader, to fill in while I'm away. He has a very unique view on the commodity markets and I'll think you'll find his viewpoint interesting and insightful.

Is Now the Time to Sell Oil?

Most investors have a commonly held belief that oil speculators are to blame for high oil prices. Certainly there is some anecdotal evidence to suggest that speculators can move the markets. After a 20 percent run-up in crude oil since December, long-term commodity bull Goldman Sachs (NYSE:GS) recently warned clients to take some profits off the table. The large investment bank estimates suggest speculators are inflating the price of crude as much as $27 a barrel.

Goldman is certainly right about one thing: Speculators have pushed the price of oil to levels not seen since September 2008. But does that mean you should liquidate all of your oil-related holdings?

I thought it might be interesting to look at what happens to the price of oil in the weeks and months after lots of oil speculators flood the markets with long positions. This is what I came up with.

According to the U.S. Commodity Futures Trading Commission (CFTC), large speculators are nearing the net-longest in the history of crude oil futures. Contrary to what the talking heads would have you believe, historically, extreme net-long positions in oil futures have not been a consistent indicator.

This chart shows that speculators have more long positions than at any point over the past nine months. Everyone is betting one way, so it might stand to reason that a good contrarian investor should bet the other way.

[Click all to enlarge] 5.10.11 1.PNG

After looking at the chart, there is no denying that speculators have jumped in with both feet, pushing their net long position to one of the largest in history.

As a general rule of thumb, taking the other side of speculator extremes in commodities is a workable strategy. You have to be careful, since commodities can get stuck in supply/demand imbalances that will overrule anything else, but as a rule of thumb it's pretty good. So we might expect to see negative returns when looking at crude oil's future performance after large speculators become extremely net long. Let's check, going back to 1986:

After Large Speculators Have Reached Extreme Net Long Positions in Crude Oil Futures 5.10.11 2.PNG

After Large Speculators Have Reached Extreme Net Short Positions in Crude Oil Futures 5.10.11 3.PNG

Well, that's surprising. Crude's future returns were precisely the opposite of what one might expect. Three months after speculators had become the net longest in at least three years, crude sported gains 79 percent of the time, and had a median maximum gain that was twice as large as the maximum loss.

The opposite was also contrary to expectations. When speculators were extremely net short, we would expect crude to bounce. But three months later, it was positive only 25 percent of the time, and had exceptionally negative average returns.

Volatility in all cases was extremely high. Something else to note is that when speculators were extremely net long, like now, much of the maximum loss happened right away -- within the first month after the extreme. Same goes for the opposite: When speculators were extremely net short, much of the knee-jerk bounce occurred within the first month.

So if we're going to look at this in a contrary way, we'd probably best be served by watching for an immediate reaction, since we don't really have any historical legs to stand on longer-term.

So far this conclusion is true. After speculators hit the latest net-long extreme oil has taken a bit of a reprieve losing 4.5 percent over the past week. Now we will have to wait and see if the statistics hold true over the next six months.

Investment implications: If you're looking for a time to build or add to a position in an oil investment, you should wait for a time when there are lots of net-long positions, as there are now. Buy your investment on dips during this period, and higher priced oil should reward you handsomely.

If you're looking for an investment with the best upside to higher oil prices, I would suggest the oil services ETF. These companies typically become more profitable the higher oil's price goes. 5.10.11 4.PNG

The Oil Services ETF (NYSEARCA:OIH) is comprised of the top 14 companies within the oil services industry. Besides commodity futures, oil services are the most levered to higher oil prices. Simply put, they are the most direct and lucrative way to take advantage of price increases in crude oil.

Investing in OIH relieves you of the difficult task of stock picking. The ETF provides excellent exposure to an energy sub-sector that will benefit from increased global demand and upcoming inflation.