MarketPsych Report: The Predictability of Crude Oil, Fear, and War

I grew up in West Texas, near where wildcatters such as George Bush senior made their fortunes. Oil pumpjacks, rusty and retired after the oil price collapse in the early 1980s, sat idle across the scrubland near my house. For high school kids, those pumpjacks were popular props for spending weekend evenings. There was nothing more pleasant than laying on the cold steel of a pumpjack under the stars, chatting with friends, a bonfire burning far below us.

Being adolescent and thus maintaining our right to poor judgment, it hadn't occurred to us that lighting bonfires on top of decrepit oil pumpjacks could lead to a lethal explosion. It took an incredulous county sheriff to point that out to us one night.

Those disused pumpjacks are pumping again. The bust in oil prices that left such pumpjacks quiet and rusting in the Texas scrub has ended. Sometimes oil price boom/bust cycles are driven by supply and demand imbalances (as in the early 1980s); and other times they are driven by fear and war.

Fear has the opposite relation with oil prices as equity prices. When fear is high in stocks, it is generally a good time to buy. With oil the opposite relationship holds.

Most investors know they are implicitly long the stock market, but sometimes we are long or short assets in hidden ways, making diversification difficult. Just as it took a financial crisis for me to realize that my career is long the financial industry (regardless of how much I was short equities), it often takes a price shock for consumers to realize that - by virtue of their daily heating, transportation, and consumption needs - they are implicitly short oil. Unless your career is in the energy industry, you have a substantial lifetime short position on crude oil.

Fear about oil supply shocks and their reverberations through politics and the economy creates one of the most predictable patterns our analysts have seen in any commodity. This month's newsletter examines three variables we've identified that drive oil prices - Fear, Conflict, and Violence. The letter goes on to give an outlook for oil prices based on the Syrian conflict. But before we jump into an analysis of how fear and conflict drive the oil price, we've got some interesting news.

At MarketPsych Data we've been gradually utilizing our data to augment the academic research on sentiment driving asset prices. We also find that sentiment can be integrated into charts, to improve technical and fundamental analysis. Our new 16-slide presentation demonstrates how sentiment data can broadly be used to improve trading and investment returns with academic references.

Now that our Thomson Reuters MarketPsych Indices (TRMI) are being studied by academic researchers, we're seeing fascinating results start to roll in. Here's a video by researchers at the Stevens Institute of Technology and Thomson Reuters R&D discussing how our data is helping to solve the "Forward Premium Puzzle" in currencies, answering the question, "why does the carry trade work?": http://vimeo.com/72430790.

What Drives Oil Prices?

"The Strait of Hormuz is the world's most important oil chokepoint due to its daily oil flow of about 17 million bbl/d in 2011.... Flows through the Strait in 2011 were roughly 35 percent of all seaborne traded oil, or almost 20 percent of oil traded worldwide."

~ U.S. Energy Information Administration, August 22, 2012.

"If they (the West) impose sanctions on Iran's oil exports, then even one drop of oil cannot flow from the Strait of Hormuz."

~ Iranian Vice President, Mohammad Reza Rahimi, December 27, 2011.

Before oil was a common energy source, it was used as a weapon. The following image from a Greek manuscript demonstrates the use of a petroleum-based fire-spraying weapon during naval combat.

Now that economic warfare is being touted as a more effective weapon to assert power than military warfare, oil is still used for combat, but in a more stealthy fashion.

In looking through our charts on oil, we noticed an interesting pattern around several of the war and conflict-related oil price highs of the past decade. From the U.S. invasion of Iraq in 2003 to the air war against Muammar Quaddafi in spring 2011 to the Iranian-Israeli tensions over Iran's nuclear program in early 2012, we've seen the oil price repeatedly driven high by conflict in oil-producing nations.

In the following chart, you can see the spike in oil prices around the NATO air war on Libya.

More recently we see the same pattern around U.S. and Israeli threats to forcibly dismantle Iran's nuclear program. See the chart below:

Using a chart similar to the one above, our March 2012 newsletter predicted a slide in oil prices.

Having seen such patterns in our data, we decided to run a statistical study to establish if there is statistical significance - and trading opportunities - based on these patterns.

The Predictability of Fear, Violence, and Oil Price Volatility

"The international energy market is dependent upon reliable transport. The blockage of a chokepoint, even temporarily, can lead to substantial increases in total energy costs."

~ U.S. Energy Information Administration, August 22, 2012.

Academic research shows that a small probability of an emotional event occurring - such as an oil supply shock or a military assault - are over-weighted in human probability assessments. As a result of this overweighting, humans overreact to even the mention of possible vivid, negative events. Overreaction refers to the tendency of asset prices, after violently moving in one direction, to drift back towards their origin. Fear is a measure of overreaction - an indicator that risk is being seen as greater than it actually is. So when fear is high, odds are that investors are overreacting to some vivid negative event, and prices are likely to revert to their pre-crisis level once fear begins to wane.

We ran a series of simple data mining experiments to sort out how Conflict, Violence, and Fear have predicted oil prices over the past 14 years. If you've got an aversion to data-mining, then you'll have lots of bones to pick with our analysis, but in our experience oil investors find these results illuminating. This is not a formal back-tested study, but rather we fit our data to the entire historical 14-year period to see if we could glean useful insights.

METHODS

We know from experience and research that sentiment and news are nonlinear - that is, important information hits the markets in bursts and is typically only significant at high levels.

Using our Thomson Reuters MarketPsych Indices (TRMI) as independent variables, and changes in the highest-volume futures contract of West Texas Intermediate Crude as our dependent variables, we investigated how different intensities of the TRMI's Fear, Conflict and Violence impacted oil prices. Using TRMI data up to the day's futures market close, we then forecasted the price from the following day's open price to the open price one month in the future. We tested 14 years of TRMI Crude Oil data. Our statistical software was custom-designed by our legendary former fund CTO Yury Shatz, and has been enhanced to analyze vast arrays of asset prices by our Chief Data Scientist, Aleksander Fafula, PhD.

In our sentiment data, Conflict refers to high levels of dispute and disagreement surrounding the oil markets. Violence refers to military threats and actions associated with the oil market. Fear is a measure of references to "worries," "concerns," and other symptoms of anxiety surrounding oil prices.

AS CONFLICT HEATS UP

After analyzing our data, we saw an interesting story emerge. First of all, when the news of a conflict or potential war hits the market, it does of course cause a spike in prices. Importantly for traders, that spike has momentum - oil prices continue higher for the following month.

For example a one week spikes in Violence (91 times in the past 14 years, 2.2% average following month return) and Conflict (94 times, 3.2% average future one-month return) lead to high returns. Amazingly, these "spikes" are only changes above average, and as a result cover half of all sampled months. We see a similar positive momentum effect for Fear, but only at high levels of change, probably because Fear is a relatively sparse variable. A rise in one week fear greater than 90% of all such spikes happens 19 times with average 3.2% monthly returns.

When we look at two variables together such as when Conflict rises AND ProductionVolume drops, the following month shows an average return of 8.2% (28 occurrences, 82% accuracy). This is an important result because it is predictive and it is common and it explains what drives prices higher - both conflict AND concerns about declining production. Oil traders have time to enter into these positions.

So we can see above that rising Conflict, Violence, and Fear stimulate further price rises, and these price increases are predictable. It appears that oil traders take their sweet time positioning themselves when tensions rise. This reinforces our personality test finding that speedy reaction time is one of the key traits of top traders.

WHEN CONFLICT IS BOILING

Despite seeing increases in Fear, Violence, and Conflict driving prices higher, static high levels of these sentiments actually precede price declines.

When the 3-month average of Fear is in the top 20% of its historical range, the Crude Oil price drops an average of -1.8% over the next month (37 samples). For Conflict in the top 20% of its historical range, the drop is -3.2% over the next month (37 samples).

When we again look at Conflict paired with another variable (an Association Rule), we find that high average levels of Conflict paired with a sudden one-week drop in Urgency precedes an average -5.5% (19 samples) drop in the crude price over the next month. When Urgency declines (the crisis ends), paired with high average 3-month levels of Conflict, there is a predictable opportunity to short oil and profit.

Trading Corner

"Iran's and Syria's defense ministers threatened on Friday to unleash attacks on Israel if Mr. Assad was in danger."

~ New York Times, August 30, 2013

The Syrian use of chemical weapons and the potential for Western involvement in the Syrian civil war are putting oil markets on edge. Our latest oil Conflict, Fear and Violence data series can be seen in the following chart:

This chart shows that tensions have been gradually rising, alongside the oil price, since May 2013. The chart demonstrates what our data research told us - price momentum in oil is driven by the conflict and the expectation of production-disrupting war.

We're in a good time of year for psychology-based forecasting. So far this summer, our real-time model of global economic activity, based on the content of the news flow, have been indicating that Germany and the Eurozone are growing strongly. Confirmation of our models' reports of increasing Eurozone growth came this month. We have additional outlook, including our thoughts on the direction of crude oil in our subscription newsletter. Please subscribe for specific investment ideas.

Housekeeping and Closing

We've got a busy 2013 ahead, with speaking engagements in New York, Toronto, Philadelphia, Orlando, San Francisco, Providence, Amsterdam, Berlin, Panama, and Accra. We look forward to reconnecting with our friends in those cities! Please contact Derek Sweeney to book us for a talk or training at one of your events: Derek@thesweeneyagency.com, +1-866-727-7555.

If you represent an institution, please contact us for research reports specific to markets or assets you are watching. We find that our psychological research can help analysts and portfolio managers understand price action in markets that have deviated from fundamental drivers.

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 140 countries, 40 equity sectors and industries, and 5,000 U.S> and global equities extracted in real-time from millions of social and news media articles every day.

We love to chat with our readers about their experience with psychology in the markets and with behavioral economics! Please also send us feedback on what you'd like to hear more about in this area.

Happy Investing!

Richard L. Peterson, M.D. and The MarketPsych Team

Books
Both books named "Top Financial Books of the Year" by Kiplingers.

MarketPsych: How to Manage
Fear and Build Your Investor Identity

Inside the Investor's Brain:
The Power of Mind Over Money (Wiley Trading)

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