Harnessing Gains from Mean Reversion in WTI Crude FuturesThere are three kinds of lies: lies, damn lies, and statistics. Fortunately, not always. Statistics enables investors and traders in financial and commodity markets.
In statistics, mean is also known as the average. It is a number that represents the entire data set. Mean is the sum of the data set divided by number of data points in it. For example, in a group of six men who weigh between 70kg to 80kg with an interval of two kilograms apart, the mean weight of the group is 75kg.
Previously, Mint published two case studies looking at WTI crude oil futures. a short position and a long position . Both of these case studies were centered upon the same range-bound price action of WTI futures.
Mean Reversion in Financial & Commodity Markets
In financial markets, mean refers to the average of all the data observations. For example, let's say in WTI futures, it refers to the average price of a barrel of WTI futures over the observed period.
For commodity traders, mean and reversion to the mean is a godsend.
Reversion to the mean is a consistent occurrence in finance. Especially in crude oil, ample academic research shows that crude oil prices tend to mean revert.
In other words, crude oil prices has a tendency to stray away from the mean but will eventually retrace back to the longer term average. Asset prices oscillate around the average. The bigger the diversion from the mean, the higher the probability that prices will revert to it.
Harnessing Mean Reversion in Financial Markets
An astute trader can identify the pattern embedded in the price. Such traders carefully ride the path of the asset prices to gain from it and switch their positions around when prices start to trace back.
This phenomenon has led to the development of many investing and trading strategies that involve the buying & selling assets whose prices have veered away from their historical averages.
At its core, trading the mean reversion strategy involves buying the asset whose values have fallen below the long-term average and waiting for prices to recover back up to the long-term mean before selling it.
Trading strategies are based on either taking advantage of mean reversion or momentum in the market. Markets spend greater time in consolidation mode relative to trending phases. Incorporating mean reversion in trading strategies is not only important but potentially lucrative.
For those assets, whose prices are far above the mean, the strategy would then involve selling the asset first in the hope of a price correction to the mean. When prices fall, the asset is bought back at a lower price to lock in the gain.
Mean Reversion is not Guaranteed. Take Caution.
Readers to take caution that mean reversion is not guaranteed. Unexpected highs or lows could indicate a shift in the norm. A significant price change could be structural indicating a new normal. The structural shift may provide a significant headwind or tailwind to asset prices in the longer run.
Technical Indicators to help identify Mean Reversion
This paper aims to illustrate mean reversion using WTI Crude Oil futures. Crude oil prices are known to follow Brownian motion with mean reversion, according to academic literature. WTI Crude Oil futures follow a lognormal distribution with slowly changing volatility.
Brownian motion? Lognormal distribution? Park them aside for now. Mint will cover those topics in another educational paper in near future.
Effective mean reversion involves effective timing of trade entry and exits. Trend following indicators, such as moving averages help to identify patterns. Oscillators, such as the RSI, also enable investors to identify overbought and oversold conditions. Bollinger Bands is a complementary indicator to identify mean reversion trend.
Mean Reversion in Crude Oil Prices in 2022 and 2023
WTI crude oil prices soared in the first half of 2022 as the war in Ukraine clouded supply projections after sanctions were placed on Russian oil and gas by the US and EU. This reduced the available supply pushing prices higher.
However, during second half of the year, the gloomy global economic outlook and recession risks in the US meant that demand for crude oil started to drop. Moreover, COVID outbreaks in China meant that the largest importer of Crude Oil had lesser appetite to buy.
Over the past 3 months, WTI Crude Oil has traded in a tight range between $70 to $80 a barrel. The reasons behind the range bound price action are:
At the bottom end of the range, there is strong support between $67-72 as that is the price range that the US DoE plans on purchasing oil to replenish the Strategic Petroleum Reserve.
At the top end of the range, supply outpacing demand, as well as the availability of cheap Russian oil for major consumers – China and India – limits the upside potential for oil.
Capex into new oil exploration has dropped as the world starts to shift towards alternative energy sources.
Despite the SPR currently at a 40-year low, the Biden administration continues to draw more crude from the reserves
to limit fuel price inflation in the US & keeping WTI crude prices lower.
