5 Steps to Making a Profit in Crude Oil Trading

Fact checked by Michael LoganReviewed by Chip StapletonFact checked by Michael LoganReviewed by Chip Stapleton

Crude oil trading offers excellent opportunities to profit in nearly all market conditions due to its unique standing within the world’s economic and political systems. Energy sector volatility can produce consistent returns for short-term swing trades and long-term timing strategies.

Market participants often fail to take full advantage of crude oil fluctuations, either because they haven’t learned the unique characteristics of these markets or because they’re unaware of the hidden pitfalls that can eat into earnings. In addition, not all energy-focused financial instruments are created equally, with a subset of these securities more likely to produce positive results. 

Key Takeaways

• If you want to play the oil markets, this important commodity can provide a highly liquid asset class with which to trade several strategies.
• First, decide what is appropriate for you: a spot oil (and if so what grade); a derivative product such as futures or options; or an exchange-trade product like an ETN or ETF.
• Then focus on the oil market fundamentals and what drives supply and demand, as well as technical indicators gleaned from charts.

Here are five steps needed to make a consistent profit in the markets.

1. Learn What Moves Crude Oil

Crude oil moves through perceptions of supply and demand, affected by worldwide output as well as global economic prosperity. Oversupply and shrinking demand encourage traders to sell crude oil markets while rising demand and declining or flat production encourage traders to bid crude oil higher.

Tight convergence between positive elements can produce powerful uptrends, like the surge of crude oil to $145.31 per barrel in July 2008, while tight convergence between negative elements can create equally powerful downtrends, like the August 2015 collapse to $38.22 per barrel.

Price action tends to build narrow trading ranges when crude oil reacts to mixed conditions, with sideways action often persisting for years at a time.

2. Understand the Crowd

Professional traders and hedgers dominate the energy futures markets, with industry players taking positions to offset physical exposure while hedge funds speculate on long- and short-term direction. Retail traders and investors exert less influence here than in more emotional markets, like precious metals or high beta growth stocks.

Retail’s influence rises when crude oil trends sharply, attracting capital from small players who are drawn into these markets by front-page headlines and table-pounding talking heads.

The subsequent waves of greed and fear can intensify underlying trend momentum, contributing to historic climaxes and collapses that print exceptionally high volumes.

3. Choose Between Brent and WTI Crude Oil

Crude oil trades through two primary markets, West Texas Intermediate Crude and Brent Crude. WTI originates in the U.S. Permian Basin and other local sources while Brent comes from more than a dozen fields in the North Atlantic. These varieties contain different sulfur content and API gravity, with lower levels commonly called light sweet crude oil. 

Brent is a better indicator of worldwide pricing, being more heavily traded in the world futures markets.

Pricing between these grades stayed within a narrow band for years, but that came to an end in 2010 when the two markets diverged sharply due to a rapidly changing supply versus demand environment.

The rise of U.S. oil production, driven by shale and fracking technology, increased WTI output at the same time Brent drilling underwent a rapid decrease.

U.S. law dating back to the Arab oil embargo in the 1970s aggravated this division, prohibiting local oil companies from selling their inventory in overseas markets. This ban was removed in 2015.

Many of CME Group’s New York Mercantile Exchange (NYMEX) futures contracts track the WTI benchmark, with the “CL” ticker attracting significant daily volume.

The majority of futures traders can focus exclusively on this contract and its many derivatives. Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) offer equity access to crude oil, but their mathematical construction generates significant limitations due to contango and backwardation.

4. Read the Long-Term Chart

WTI crude oil rose after World War II, peaking in the upper $20s and entering a narrow band until the embargo in the 1970s triggered a parabolic rally to almost $70. It peaked late in the decade and began a torturous decline, dropping into the $20s ahead of the new millennium.

Crude oil entered a new and powerful uptrend in 1999, rising to an all-time high at $201.04 in June 2008. It then dropped into a massive trading range between that level and the upper $50s, settling around $56 at the end of 2018. As of July 2024, it was trading at about $81.

5. Pick Your Venue

The NYMEX WTI Light Sweet Crude Oil futures contract (CL) trades in excess of 10 million contracts per month, offering superb liquidity. However, it has a relatively high risk due to the 1,000-barrel contract unit and the .01 per barrel minimum price fluctuation.

There are dozens of other energy-based products offered through NYMEX, with the vast majority attracting professional speculators but few private traders or investors.

The U.S. Oil Fund offers the most popular way to play crude oil through equities, posting an average daily volume of about 2 million shares. This security tracks WTI futures but is vulnerable to contango, due to discrepancies between front-month and longer-dated contracts that reduce the size of price extensions.

Oil companies and sector funds offer diverse industry exposure, with production, exploration, and oil service operations presenting different trends and opportunities.

While the majority of companies track general crude oil trends, they can diverge sharply for long periods. These counter-swings often occur when equity markets are trending sharply, with rallies or selloffs triggering cross-market correlation that promotes lockstep behavior between diverse sectors.

Some of the largest U.S. oil company funds are:

• SPDR Energy Select Sector Fund (XLE)
• SPDR S&P Oil & Gas Exploration and Production ETF (XOP)
• VanEck Vectors Oil Services ETF (OIH)
• iShares U.S. Energy ETF (IYE)
• Vanguard Energy ETF (VDE)

Reserve currencies offer an excellent way to take long-term crude oil exposure, with the economies of many nations leveraged closely to their energy resources.

U.S. dollar crosses with Colombian and Mexican pesos, under tickers USD/COP and USD/MXN, have been tracking crude oil for years, offering speculators highly liquid and easily scaled access to uptrends and downtrends. Bearish crude oil positions require buying these crosses while bullish positions require selling them short.

What Is Crude Oil?

Crude oil is a fossil fuel found underground formed from the remains of plants and animals from millions of years ago. Crude oil is yellow to black in color and functions as fuel or as a raw material. Crude oil is refined into various petroleum products, including jet fuel, gasoline, diesel, kerosene, lubricants, and other products.

What Is Crude Oil Trading?

Crude oil trading is the buying and selling of crude oil or other oil-linked assets to make a profit. As crude oil is a widely used commodity and its extraction and refinement is complex, along with its limited availability, and the geopolitics that surround it, the prices of oil and oil-linked assets fluctuate widely. Traders seek to take advantage of these fluctuations to generate returns. Oil can be traded in a variety of ways but the most common is through oil futures.

How Do I Invest in Crude Oil?

For the average investor, the best way to invest in crude oil is to buy the stocks of oil and gas companies. Another good avenue is to invest in ETFs that track the energy sector or specific crude oil ETFs.

The Bottom Line

Trading in crude oil and energy markets requires exceptional skill sets to build consistent profits. Market players looking to trade crude oil futures and its numerous derivatives need to learn what moves the commodity, the nature of the prevailing crowd, the long-term price history, and physical variations between different grades.

Read the original article on Investopedia.