How To Trade Crude Oil To Avoid More Losses

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Includes: BNO, CLR, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, UGA, USL, USO, UWTI
by: Robert Boslego

Summary

Oil prices surged 20% in past six trading sessions.

The production "freeze" does not change production.

This price action reflects cognitive and emotional biases.

Investors need to factor in fundamentals, risk management and behavioral biases.

Investment management is the "management of risks.".

On Friday, February 12th, the March crude futures contract spiked 12.2% based on speculation of a possible OPEC agreement to reduce oil production. Instead, Saudi Arabia and Russia announced on Tuesday that they had tentatively agreed to "freeze" their production at January's level, as long as other producers participated.

The "deal" was meaningless from the standpoint that the two big producers were already maximizing their production. In fact, Russia's output is likely to decline slightly in 2016 due to aging fields. Even more significantly, Iran is committed to increasing its production following the lifting of sanctions.

The subsequent daily price changes through today have added a total of 20% to nearby crude futures prices -- without any production cut or even any mention of one.

 

Crude Futures Price

 

Change

Cumulative

2/12/2016

12.20%

12.20%

2/16/2016

-0.95%

11.13%

2/17/2016

5.54%

17.29%

2/18/2016

0.07%

17.37%

2/19/2016

-3.49%

13.28%

2/22/2016

6.20%

20.30%

Click to enlarge

What's Going On?

Many investors like to believe that the fundamentals of supply and demand determine oil prices. And I would argue that they do determine the price range.

But like equity markets, oil markets are not "efficient," immediately and accurately reflecting the fundamentals. In his paper "From Efficient Markets Theory to Behavioral Finance", Nobel laureate Robert Shiller discusses the failure of the efficient markets theory to explain stock market prices and the "blooming of behavioral finance." In particular, he describes one of the oldest theories about financial markets, which he calls price-to-price feedback theory. Essentially, he argues that the emotions of greed and fear drive market prices far too high on the upside, and much too low on in downturns.

In addition to this "bias" that make investors act irrationally, behavioral finance has identified a number of other emotional and cognitive biases. One of the most pervasive is "confirmation bias."

Behavioral finance describes this cognitive phenomenon this way: "the tendency to search for, interpret, favor, and recall information in a way that confirms one's beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities." People also tend to interpret ambiguous evidence as supporting their existing position.

It is considered to be a systematic error of inductive reasoning. People are biased toward confirming their existing beliefs. The effect is stronger for emotionally-charged issues and for deeply entrenched beliefs.

After oil prices peaked in June 2014, a large segment of the market has held on to their oil-related investments believing in their investment thesis that oil must continue to rise over the next 20 years as supplies are depleted and demand rises globally.

When prices dropped below $100 in October 2014, Harold Hamm, CEO of Continental Resources (NYSE:CLR), even lifted his short hedges for 2015, so sure was he that prices had to remain about $100 per barrel. After OPEC announced its price war at the November 2014 meeting, investors stuck with their thesis that oil prices had to rebound quickly.

Evidence that oil inventories were surging in the U.S. and worldwide was discarded because the oversupply was "waver thin." Numerous articles appeared on Seeking Alpha throughout 2015 proclaiming that "the bottom was in."

A good recent example of confirmation bias was just written by an author:

I believe the "freeze" is a first step, a baby step, on the path to a production cut that will result in unanimous consent by all members of the cartel."

An understanding of OPEC's historical behavior and cartel dynamics virtually assures that such a development will never be implemented.

What Are the Keys?

In addition to having objective forecasts of supply and demand that are continuously updated to reflect expectations and risks which identify a price range, there are two other components to successful investing in the oil market. The first is an effective price risk management approach and the second is a way to assess the effects of greed and fear.

In The Intelligent Investor, Benjamin Graham states, "the essence of investment management is the management of risks, not the management of returns." At the heart of this approach is loss minimization, deliberately protecting oneself against serious losses. Warren Buffett described this book as "by far the best on investing ever written." By limiting losses, an investor stands a much better chance of recovery. When losses become too deep, the gains required to recover become overwhelming. For example, if an account loses 50%, a 100% gain is required to recover.

To quantify conditions that might make investors feel greedy and fearful, I developed and tested hypotheses. It turns out that the size of market gains and losses, combined with the momentum, does a pretty good job in determining when to be long, when to be out, and when to get short. I have written about this process in this article.

Conclusions

The surge in oil prices over the past six trading sessions is a perfect illustration of the effects of behavioral biases v. an "efficient market" reaction. Investors want to believe that oil prices will recover and they buy on the weakest of news.

I have recently written that OPEC and the Russians could probably add $5 to $10 per barrel by continuing to make hints that they might agree to a cut. OPEC could collect $5 billion to $10 billion a month without cutting back.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.