Volatile Oil Prices: What Should Investors Do?

By now you have figured out that oil prices are going crazy. What few investment professionals mention is that, besides always being beholden to supply and demand, commodities like oil will always be extremely volatile. As such, investing in anything connected to commodities, especially oil, will carry a lot of volatility risk with it.

We saw oil fall to $60 where it seemed to stabilize. Then it fell to under $40, and then surged back up towards $50, only to fall again back into the low-40s.

What’s going on and how do we, as investors, deal with these volatile oil prices?

First, let’s remember the underlying reason for why oil is down in general. It mostly has to do with China’s slowing economy. Because the oil market is already oversupplied, adding weakening demand from China means there is an even greater demand-supply imbalance.

Remember, when supply exceeds demand, prices fall. When investors see the China stock market crash, as has been occurring over the past few weeks, the fears over a weakening economy get worse, so, supply concerns grow and oil prices fall even more.

Growing Oil Supply Imbalance

Meanwhile, oil producers have spent billions to create technology that makes exploration more efficient. With exploration and extraction easier, the producers don’t want to waste all that research and development money, so they keep producing, creating an even bigger supply imbalance.

The most recent volatility is probably related to these issues, but more likely, they are related to overall market volatility. The market bounced back form the correction in a big way and carried oil along with it.

However, this recent surge is also a common phenomenon with any security that has seen a huge decline. Some call it a “dead cat bounce.” Others refer to it as short covering. Some people are just buying the dip.

It’s generally fruitless to try and call a bottom in oil because of all the crosscurrents. However, there are a few tools in the technical analysis playbook that can come in handy to guide us towards some trading advice.

Let’s look to other periods of crazy oil prices, with big oil spikes and declines. In 2008, oil spiked to $145. During the 1970’s oil embargo, they spiked to $115.

Let’s examine the following long-term West Texas Intermediate crude chart:

Source: MacroTrends

The oil embargo was followed by a 78% decline. The 2008 spike resulted in a 70% retracement. Both of these numbers are close to what is referred to as “Fibonacci retracement levels.” That term refers to areas of support (price stops going lower) or resistance (price stops going higher). The Fibonacci retracement is the potential retracement of a financial asset’s original move in price.

So far, we’ve seen a 63% decline off the $104 high to about $38, which is just about at that 61.5% Fibonacci level. Some traders think that may be a bottom and that we will test it. A 78% decline from the most recent high would take us to $24, or to $34 in the case of the post-2008 high.

So if you conclude, as I do, that oil is going to bottom somewhere between $24 and $38, here’s what you do as an investor.

When Volatile Oil Prices Fall

Energy remains a must-own. If anything, you have a chance to get in at lower prices today than last year. So you can get started by opening some positions, but only open partial positions in case you need to average down.

So every time oil falls about $4 or so, add to your position – at $34, $30, $26, etc. – and then see if $24 is breached. Just nibble at each level.

What do you buy in this environment of volatile oil prices? Any big name like Exxon Mobil (NYSE: XOM),Chevron (NYSE: CVX), ConocoPhillips (NYSE: COP) or similar. You can also do what I do, which is to buy the Energy Select Sector SPDR Fund (NYSEArca: XLE) and the Market Vectors Oil Services ETF (NYSE: OIH).

SOURCE: http://www.wyattresearch.com/article/volatile-oil-prices/