What's The Best Way To Profit From A Potential Rebound In Oil?

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Includes: USO
by: Aristofanis Papadatos

Summary

Many investors wonder which is the best way to profit from a potential rebound of oil in the next 1-3 years.

The oil futures and the oil ETFs involve a great cost of time, the contango cost.

The oil stocks, which have historically been a good proxy for the oil price, have already priced in a strong rebound of oil and hence they carry significant risk.

The best choice is probably the purchase of Brent futures that expire in December-2016 or December-2017, as Brent has a much lower contango than WTI.

Crude oil hit a new 13-year low of $26.05 last week before bouncing to $29.44 and is almost 75% down from its peak in the summer of 2014. In addition, its bear market has lasted much longer than most analysts initially expected. Nevertheless, as the current price of oil has rendered numerous production wells unprofitable and has thus led most producers decimate their investment projects, it is only natural to expect higher prices in the future. Therefore, many investors wonder which is the best way to profit from a potential rebound of oil in the next 1-3 years.

The most obvious way is to purchase prompt month futures of WTI or Brent. However, when the price of oil is depressed, its futures are characterized by a contango structure, i.e., the distant futures are much more expensive than the prompt futures. This results in a remarkably high cost of time; the owners of the futures have to pay this cost every month in order to roll their positions into the next month. At the moment, the size of the contango or the time cost is 8.4% (for the first month) for WTI and 1.9% for Brent. Therefore, as long as a strong rebound does not materialize soon enough, investors incur an extra cost that is really burdensome and continuously erodes the value of their position.

Most investors are well familiar with this time cost of the oil futures and consider purchasing The United States Oil ETF (NYSEARCA:USO). Unfortunately for them, the ETF suffers from the exact same problem, as it has to roll over its oil futures every month. Consequently, while the ETF holders may not feel the pain of rolling over their contracts every month, the performance of the ETF suffers due to this time cost and hence the ETF does not have any advantage over its underlying futures. This explains the pronounced underperformance of USO vs. the price of oil. For instance, only in the last 6 months oil has lost 30% while USO has lost 41%. Therefore, both the oil futures and the oil ETFs have the handicap of contango and hence they can offer profits only if oil rallies strongly and fast enough from the initiation of a position. If the timing is wrong, it is extremely unlikely to retrieve the initial losses, even if a significant rebound occurs after a while. To make a long story short, investors should have great timing skills in order to profit from these investment vehicles but the truth is that almost no-one has such skills.

Due to the above mentioned handicap, some investors use the stocks of oil producers as a proxy for the oil price in order to avoid the contango issue. Those investors will consider the oil stocks to be a superior alternative, as the stocks pay a dividend in every quarter instead of charging investors with the contango cost. Unfortunately, although this may have been true at some point in the past, at the moment it is a complete fallacy. More specifically, the major oil stocks have already priced in a strong rebound of oil. To be sure, Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and BP (NYSE:BP) are currently trading at a forward P/E of 32, 51.4 and 22.7, respectively. As these P/E ratios are extremely high, both in absolute and historical perspective, they are unsustainable in the long term. Hence it is evident that the market has already priced a strong rebound of oil into these stocks. In order for the P/E ratios of these stocks to return to normal levels around 15, the oil price would have to rebound to at least $60-$70. Therefore, if the price of oil remains depressed around its current levels for the whole year, the oil stocks are likely to significantly fall from their current levels. All in all, the handicap of contango is present even in the oil stocks and hence investors cannot avoid the cost of time by resorting to them. This is a hidden risk that can cost significant losses to those who do not realize it. Even a well-written article that made it to the TOP 10 last week suggested buying oil stocks to avoid the contango-generated losses.

To conclude, most investors believe that the current oil prices are unsustainable and would like to profit from a rebound of oil in the next 1-3 years. However, all the available investment vehicles carry the contango cost. This means that investors will profit only if they have excellent timing skills, which is very unlikely. Alternatively, they can profit if the rally is so strong that it can exceed the time cost of contango but it is not advisable to invest with a huge handicap. In my opinion, the best available choice at the moment is to purchase the futures of Brent that expire in December at $38.9. As the contango of Brent is much less pronounced than that of WTI (the prompt month is at $33.36), the time cost of Brent should be acceptable to investors who believe in a strong rebound of oil. Of course the December contract will rally less than the prompt contract in the case of a strong rebound but it will also fall less in the case of a downturn in the oil price. Therefore, it is a somewhat defensive choice. Alternatively, if investors want to take an even longer-term horizon, they can purchase Brent of December-2017 at $43.84. By that time the huge budget cuts of oil producers will have taken their toll on the supply of oil and hence the price of oil will probably be much higher than the low 40s.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.