After a heavy dose of doom and gloom, the oil markets seem to be finally getting their footing back. Crude prices have almost fully retraced their historic nosedive three weeks ago, with WTI crude for June delivery following up Monday's 22% rally with a 13.5% gain at 9 am ET on Tuesday.
The bullishness has been triggered by the first production cuts by OPEC+ coming online on Monday. At the same time, scores of independent producers (IOCs) in the U.S., Canada, and Norway have announced their own voluntary cutbacks. Meanwhile, oil demand appears to be slowly creeping back, though the jury is out as to how long the climb back to the top is going to be.
Alarmingly, oil punters, bottom hunters, and speculators have doubled down in a buying frenzy that belies the enormous risks that underpin this volatile and fickle market.
The USO Enigma
The country's largest oil fund, United States Oil Fund LP (NYSEARCA: USO), has once again emerged as the investor favorite to play the rebound, with the ETF's long positions tripling just weeks after the fateful crash.
USO is a long-only crude oil exchange-traded fund (ETF) with a mandate to "...to track the daily changes in percentage terms of its shares' NAV to reflect the daily changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in price of USO's Benchmark Oil Futures Contract, less USO's expenses."
Investors love the ETF mainly due to its high liquidity (average daily volume of 17.5 million shares). They buy the shares believing them to be a good proxy for oil prices.
The big problem is that whereas the USO normally does a fairly good job of tracking spot prices, it can be a disaster under certain market conditions. Oil funds like USO operate quite differently from other ETFs or mutual funds which simply hold stocks or bonds because they invest in oil futures contracts. When these contracts expire, USO is obligated to either take physical delivery of the millions of barrels (a single futures contract represents 1,000 barrels of crude) to Cushing, Oklahoma, or offset the trade before the expiration.
The USO avoids taking delivery of physical oil by holding the contracts until two weeks before their expiration before selling the old contract and buying another short-term contract in its place. For example, USO sold the ill-fated May contract in the middle of April and bought a June contract in its place.
But rolling its contracts this way when the market is in contango (spot or current price is lower than the futures price)--as is currently the situation--effectively means that the fund is consistently buying high and selling low thus losing money on its trades. This can lead to USO significantly underperforming the spot oil market, even when oil is enjoying a nice rally.
But that's only part of the problem.
USO recently announced a significant change to its trading strategy by rotating out of short-term contracts into longer-term ones. Instead of being 100% invested in the closest month contract, the fund has now diversified its holdings as follows:
- ~30% in the July 2020 contract
- ~15% in the August 2020 contract
- ~15% in the September 2020 contract
- ~15% in the October 2020 contract
- ~15% in the December 2020 contract
- ~10% in the June 2021 contract
With longer-term oil contract prices typically being less volatile than shorter-term ones, even a sharp oil price rally of, say, $20/barrel would lead to a much smaller move by USO. Further, the roll costs of this diversification drive are already negatively affecting the fund's performance with the price flat since announcing the changes compared to a 60% surge by oil prices.
Source: ETF Focus
Finally, USO recently did a 1 for 8 reverse share split, a move that hardly inspires confidence in long-term investors.
Playing the oil price rebound
That said, ETFs can be a good way to play a rebounding sector without having to pick one or two stocks. Here are three worth a consideration:
- iShares U.S. Oil & Gas Exploration & Production ETF (IEO)
This is an exchange-traded fund that invests in oil and gas companies specifically focused on exploration and production. ConocoPhillips (NYSE:COP), EOG Resources (NYSE:EOG), Marathon Petroleum (NYSE:MPC), Valero Energy Corporation (NYSE:VAL), and Phillips66 (NYSE:PSX) are among its ten largest holdings.
IEO has significantly outperformed its bigger brethren, XOP, over the past three-year and one-year timeframes and also outperformed it during the last big oil rally of 2016-2018. The fund has surged nearly 73% since its March 18 low and pushing above its 50-day moving average for the first time this year.
- Energy Select Sector SPDR Fund (XLE)
The XLE is the U.S. energy market closest proxy, with holdings that include virtually all the sector's heavyweights: ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), Phillips 66, Schlumberger (NYSE:SLB), etc. As big oil stocks go, so goes the XLE, with the fund up nearly 60% since the market bottom.
- Direxion Daily S&P Oil & Gas Exp. & Prod. Bull 2x Shares ETF (GUSH)
Highly leveraged ETFs are some of the riskiest instruments to play a market as volatile as the current oil market due to the decay caused by excessive volatility.
That's why GUSH, an ETF that sought to return 300% of the daily performance of XOP, nearly wiped out investors this year. However, that changed in March when its operator, Direxion, lowered its leverage from 3x to 2x. GUSH ETF now seems to have much lower decay associated and has been tracking XOP's advances pretty accurately, gaining 184% since the March 31 change vs. 72% increase by XOP. Still, only investors who can withstand the attendant stomach-churning volatility need apply.
By Alex Kimani for Oilprice.com
More Top Reads From Oilprice.com:
- A Massive Wave Of Shut-Ins Fails To Halt Oil Price Crash
- Goldman: Don’t Expect U.S. Oil Prices To Recover Soon
- 3 Ways To Play The Oil Price Bounce