The Ultimate Crude Oil Trade Isn’t What it Seems

Key Takeaways

• Short supply in oil and natural gas coupled with high demand pushed prices to the highest levels in nearly a decade.
• Russia’s invasion of Ukraine brought swift sanctions that curtailed the country’s ability export oil and gas, which are hugely important to its economy (though they haven’t been cut off entirely).
• Markets are experiencing a short-squeeze, where people who bet against oil prices are forced to cover their positions by buying crude oil, sending prices even higher.
• We discuss some interesting strategies to consider using the Oil Volatility Index. 

In April of 2020, crude oil traded at NEGATIVE -$40.32.

Today, it briefly crested $110 per barrel, the highest prices since 2013.

What Happened

Like most supply chains, demand for oil outstripped supply. That’s led to a steady rise in crude oil prices over the past two years.

Consequently, consumers pay more for gasoline, adding another inflation pressure into the mix.

After invading Ukraine, world governments began sanctioning Russia, one of the largest exporters of oil and natural gas in the world.

Europe still takes delivery of oil and natural gas because Russia supplies nearly 30% of its petroleum and 39% of its natural gas imports. However, many of these nations have reduced their imports as have other countries.

This pushed global oil supplies even lower, causing prices in crude oil to spike.

Understanding Crude Prices

When the television talks about crude oil prices, they’re referring to the current price of the crude oil futures contract.

Crude oil futures are leveraged contracts that control 1,000 barrels of oil per contract and have a specific settlement date.

Traders, investors, manufacturers, and funds buy and sell futures. Any open contracts at settlement require the holder of the futures contract to take delivery of 1,000 barrels of crude oil.

That’s why futures went negative in 2020. With all of oil storage full, the USO ETF, which owned roughly 25% of the oil futures contracts, had to sell its contracts no matter the price. With so much selling, futures prices went negative.

What You Need to Know

Markets are in what’s known as a ‘short squeeze.’ Traders who bet against crude oil prices are now forced to buy back those same futures contracts at a loss.

That causes crude oil prices to move higher, forcing more traders to liquidate, creating a cascade effect that can lead to huge price jumps like we’re seeing.

At the same time, oil volatility, which is a measure of expected price movement in oil, has begun to rise.

Typically, oil volatility rises only when crude oil prices see significant drops. The same thing happens with volatility in stocks and other markets.

When we see it rise as prices of the commodity rise, that tends to indicate an end in the trend is nearby.

The Bottom Line: Don’t try to chase oil by buying an ETF or oil stock up here.

Sure, oil could get to $150 per barrel. But it can just as easily, and quite likely crash at some point.

We expect the Fed’s rate hikes to put pressure on oil prices next month.

In the meantime, consumers will face higher gas prices over the next few weeks.

If you’re looking for a way to play this market, keep an eye on oil volatility ($OVX). As it starts to get to extreme levels, such as a reading of 80, that should indicate a near-term top in oil prices.

At that point, you can consider short-term positions in ETFs like the Proshares UltraShort Crude (SCO) or Direxion Daily S&P Oil & Gas Exp. & Prod. Bear 2X Shares (DRIP).

But be careful. These are not products to use for investments. They are trading instruments.

For those who have invested and made money in oil and gas companies, consider taking part of your position off and reinvesting in the broader S&P 500 index.