- WTI crude oil has been in backwardation for more than a year.
- U.S. domestic oil production is expected to grow this year and next.
- USO can be held as long as the backwardation persists.
By Ivan Y.
In one of my first articles on Seeking Alpha, I suggested that U.S. Oil Fund (NYSEARCA:USO) was a sucker's bet due to contango in WTI crude oil. Contango is when the near-month contracts for WTI oil are cheaper than the contracts for later delivery dates. Since USO invests in the near-month contract, every month they must roll their contracts forward to the next month. When the market is in contango, every time they roll forward, they have to pay a little extra, which comes out of the pockets of shareholders.
However, USO is no longer a sucker's bet anymore now, because WTI crude has been in backwardation (the opposite of contango) for more than a year now. Every month when USO rolls their contracts to the next month, they pay a little less, which saves shareholders some money. As I am writing this article, the near-month October contract for WTI is $93.50, while the next month's contract is $93.05. So, if USO rolled forward a crude contract at this moment, it would save 45 cents per barrel. If you were to look all the way out to 2020, the gap gets even wider. December 2020 crude oil is currently at $87.53. The 2020 price really doesn't matter, though, because only the price differential between the near-month and next-month contract affects how much USO pays to roll forward.
Due to the savings from backwardation, USO has been outperforming WTI crude since last July. Since July 1st of 2013, USO is up 2.0%, while the spot price for WTI crude oil is down 3.4%. Year-to-date in 2014, USO is down only 1.3%, while WTI crude is down 5.4%. The difference is not big, but it is significant, and the savings for USO shareholders adds up over time. It's more than enough to compensate for USO's annual expense of 0.76%.
Explaining the Backwardation
Historically, WTI crude is usually in a state of contango. The primary reason, in my opinion, that explains the current backwardation is the belief by the market that domestic crude oil production in the U.S. will continue to increase in the future and provide the market with enough supply in future years. According to the EIA Short-term Energy Outlook report for August, domestic crude oil production is expected to average about 8.5 million barrels per day this year. This is a significant increase from 2013, and production is expected to increase even more next year.
- 7.5 million bpd (2013)
- 8.5 million bpd (expected in 2014)
- 9.3 million bpd (expected in 2015)
According to the IEA (not to be confused with the EIA), by 2016, the U.S. will be the #1 oil producer in the world, surpassing both Saudi Arabia and Russia. Kudos to anyone who predicted several years ago that this would be true. And kudos to anyone who predicted that North Dakota would be producing more oil than Libya.
Besides supply and demand, geopolitical events also play a major role in determining crude oil prices. The current geopolitical turmoil in the Middle East and Ukraine is boosting current oil prices to some degree. How many dollars per barrel that translates to is debatable. The fact that WTI oil is in backwardation shows that the market thinks these geopolitical events are only temporary problems. Therefore, a "war premium" is given to current oil prices, but prices farther out are not given the same premium, and are therefore, lower.
For a few years, even though I was bullish on oil prices, I had avoided investing in USO, specifically because of contango and the way it steals money from the pockets of shareholders. That condition no longer exists, and I believe USO has become investable for the long term as long as the backwardation remains in place. Saving a few cents every month when USO rolls forward the contracts is certainly not a good enough reason to be invested in the fund. One must first believe that oil prices are going higher or, at the very least, has found a bottom.
From a technical perspective, it does look like oil and USO are in the bottoming zone. The RSI for USO is around 30, which indicates an oversold condition, and for the last two years, USO has maintained a higher-low pattern, suggesting that the bottom is somewhere between right here and $33. If USO hasn't bottomed yet, then it should be close to one. A move below $33 would be bearish technically. And the next target would be $31.50. At that level, USO would be at a 2-year triple-bottom.