Last Updated on 3 November, 2022 by Samuelsson
Despite the continued efforts to reduce its use by looking for alternative green energy sources, oil still plays an important role in the global economy. If you trade crude oil, it pays to know the long-term cycle. But what is that?
Crude oil prices tend to show long-term cyclical patterns. And as with most non-renewable resources that trade on the commodity markets, crude oil prices rise over the long term but exhibit cyclical movements along the line. With an appropriate strategy, you can trade this long-term cycle and make money from it.
In this post, we will explain what the crude oil long-term cycle means and discuss a backtesting result of a strategy that exploits the cycle. But first, let’s explain a few points about crude oil that you should know.
What you should know about crude oil
The history of crude oil exploration and refining can be traced to 1837 in Baku, Azerbaijan, where the first commercial oil refinery was established to distill oil into paraffin used as lamp and heating oil. It was in 1846 that the first modern oil well, which reached a depth of 21 meters, was developed in Baku. Subsequently, commercial oil wells were developed in Bobrka, Poland (1854); Bucharest, Romania (1857); Ontario, Canada (1858); and Pennsylvania, USA (1859). By 1965, Pennsylvania was producing almost half of the world’s oil, and prices had risen from roughly $0.49 a barrel in 1861 to $6.59 a barrel.
Factors that affect oil prices
Basically, oil prices are affected by two key factors:
- Supply and demand: An increase in demand (or a decrease in supply) causes the price to go up. Likewise, a decrease in demand (or an increase in supply) causes the price to go down. This is how the major stakeholders in the oil industry, such as OPEC, Russia, the US, Canada, and China influence crude oil prices — by either manipulating the supply or demand for the product. However, since crude oil is mostly traded via futures contracts, oil prices are usually set in the oil futures market. Sometimes, it is also traded via forward contracts.
- Market sentiment: Market sentiment also affects crude oil prices because the mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present — as speculators and hedgers alike snap up oil futures contracts. Similarly, the mere belief that oil demand will decrease at some point in the future can result in a dramatic decrease in prices in the present — speculators would start short-selling oil futures contracts. Hence, crude oil prices can hinge on little more than market psychology. Both of the investors’ sentiment about future demand and supply changes and the actual changes in demand and supply play a part in the long-term cycle seen in crude oil price.
What does the long-term cycle mean?
By studying the historical price chart of crude oil, one can see that the price shows a cyclical pattern, even though it has an overall upward tendency over the long term. From a historical perspective, there generally appears to be a possible 29-year (plus or minus one or two years) cycle that governs the behavior of commodity prices. For example, since the beginning of oil’s rise as a high-demand commodity in the early 1900s, major peaks in the commodities index have occurred in 1920, 1958, and 1980, and oil peaked with the commodities index in both 1920 and 1980. But in recent years, it doesn’t always get up to two decades for oil prices to peak. In fact, it can peak twice in less than a decade.
Evidence of long-term cycle: backtesting result
Nautilus Investment Research tested the long-term cycle in crude oil. The backtesting covered a period between 1990 and 2020. The result of the backtesting can be seen in the table below:
Backtesting result of CL1 Long-Term Cycle Analysis
|Performance||All Trades||Long Only||Short Only||Real-Time||Buy & Hold|
From the table, you can see that the strategy has higher annualized returns than Buy & Hold: 14.1% vs. 7.4%. The result is even much better if one focuses on taking only long positions (Long Only): 39.0% compared to 7.4% from Buy & Hold. Notice that the Long-Only method had an 8/9 win ratio, which is highly remarkable. Obviously, the strategy is not suitable for short-selling; the annualized returns for short-selling is -8.7%.
See the chart below: