Oil prices are in rally mode.

In a surprise move this week, the Organization of the Petroleum Exporting Countries and its allies (OPEC+) announced a 1.16 million barrel per day (bpd) cut in production effective May 2023. This comes on the heels of a reduction in the U.S. oil rig count, which was foretold by the cautious attitude toward drilling from oil company executives in response to U.S. government policy that encourages renewable energy.

U.S. Energy Secretary Jennifer Granholm recently noted that the U.S. Strategic Petroleum Reserve (SPR) may not be refilled for years. Previously, the White House had stated that an SPR refill would begin with oil prices near $70 per barrel. U.S. oil prices fell as low as $65/bbl earlier this year but the SPR refill never materialized.

In addition, seasonal tendencies of the oil market usually deliver a tradable bottom in the spring in preparation for higher prices during the summer months, which result from increased gasoline demand and hurricane season.

The combination of a potential supply squeeze and seasonality offers a bullish dynamic for investors in the energy sector.

Bullish Season in Oil Arrives

As I’ve often noted, complex systems adapt. And their adaptation is not always what you might expect. That’s because complex systems react based on a simple principle: they find the path of least resistance and follow it to the next level of operation.

Read This Story: Oil Production Cuts: A Punch in the Mouth?

Given the ongoing machinations among Russia, China, the U.S. and now OPEC+, this summer driving season may be a tough one for drivers but an equally bullish one for investors. Moreover, in the oil market, prices are all about supply.

Here are the major factors currently driving the price of crude oil:

• OPEC+ recently announced a 1.16 million bpd cut effective in May. Russia has agreed to join in the production cuts;
• NATO sanctions have created a muddled picture regarding Russian oil and no one really knows how much oil Russia is selling to anyone, or at what price;
• U.S. drilling activity is stalling as producers balk at rising prices and confusing government policy;
• U,S. gasoline and crude supplies remain below historical norms;
• Refineries are ramping up activity in the face of falling supplies and expectations of increasing summer driving season demand;
• U.S. imports are increasing as domestic production flattens out; and
• The SPR is at a historical low and there seems to be little interest in refilling it any time soon.

Higher Prices Likely as Supply Squeeze Develops

The markets are starting to price in a supply squeeze as the above variables coalesce. Note the rise in West Texas Intermediate Crude (WTIC) after the OPEC+ announcement.

Note specifically that the Accumulation Distribution Indictor (ADI) was moving higher prior to the announcement. This means that short sellers were getting out of their positions as rumors of something coming down the pike circulated. Furthermore, the On Balance Volume line (OBV) had entered a trading range in early 2023 as longer-term traders began to nibble at crude near the lows of the recent trading range.

WTIC now has excellent support at $75-$80/bbl. A move above $85/bbl is likely to lead to a sustained rally throughout the summer as the usual influences that move oil prices higher begin to appear. Crude oil prices are well off their recent bottoms.

More to the point, Gasoline (GASO) prices are also poised to move higher. Already, regular gasoline in my general vicinity is selling for an average of $3.30 per gallon. The price hikes began immediately after the OPEC+ announcement. It was below $3.00/gal a couple of weeks ago.

As with WTIC above, note the bullish ADI and OBV in gasoline. This type of trading pattern where ADI and OBV rise aggressively while prices stay subdued is indicative of very smart money building positions quietly in expectations of higher prices at some point in the future.

Owning the Commodity

Trading the oil market can be challenging, which is why taking the direct approach may be the best of all options. One way to participate is via the United States Oil Fund LP (USO). This exchange-traded fund (ETF) is designed to follow the general price trend of the spot price of U.S. Oil (WTIC) which is stored in Cushing Oklahoma, but invests in a variety of future contracts as well.

The ETF’s price does not perfectly match the daily price changes of crude oil but does follow them closely, which means that it’s a very adequate way to participate in the general price trend of the underlying commodity. It also has options associated with it which offers an added dimension with less risk of loss depending on which strategy you choose.

If you’re more aggressive you can trade the ProShares Ultra Bloomberg Crude Oil 2X ETF (UCO). This is a leveraged ETF designed to rise or fall at two times the price of crude oil. So if crude goes up 1% on any given day, this ETF will rise close to 2% on that day. The opposite is true on a day when prices fall.

The correlation is not perfect due to fund expenses and the futures contract investment mix of the fund at any one time. But it does offer nearly 2X the potential price move. It also offers options. UCO’s prospectus specifically notes that the ETF is not designed to follow the trend of crude oil spot prices as it its price is based on an index of oil futures prices. However, its price trend is generally quite like that of the general price trend in the commodity.

The price chart clearly shows these characteristics, because it’s similar to that of WTIC and USO, including the recent action in ADI and OBV.

Oil Stocks

Oil stocks are traditionally viewed as reliable dividend producers, with companies like Exxon Mobil (NYSE: XOM) and Chevron Texaco (NYSE: CVX) leading the pack. However, their individual prices may limit the average investor’s ability to own the shares. As a result, the Energy Select SPDR ETF (XLE) may be a great way to own shares in these companies.

XLE invests in all the major oil companies as well as other oil related companies. You can check out the top 10 holdings of the ETF here.

Traditionally oil stocks bottom ahead of the commodity. And the price chart for XLE illustrates this concept quite well. XLE held a good portion of its gains after the October 2022 bottom. Most recently it bounced back above its 200-day moving average. Again, as with the other oil related ETFs and WTIC itself, you can see that investors have been putting money into these stocks as ADI and OBV are both in uptrends.

Bottom Line

Money is moving into the oil sector as smart money bets on a supply squeeze. The combination of bullish historical seasonal trends as well as a tightening of supplies is setting up the potential for higher prices into the summer. You can invest in the oil sector via ETFs and options on those ETFs.

In the current scenario, using slightly out of the money call options with expiration dates ranging from July to September may be the best way to invest in this sector.

Editor’s Note: Volatility won’t end anytime soon. But there’s a way to profit from uncertainty…and our colleague Jim Pearce can show you how.

Jim Pearce is chief investment strategist of our premium trading services Personal Finance, PF Pro, and Mayhem Trader.

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