Watching USO For Trading Signals

| About: The United (USO)
This article is now exclusive for PRO subscribers.


Oil exchange traded funds have become increasingly popular as a result of the volatility caused by the glut and provide good liquidity and activity.

Crude oil stockpiles have the strongest correlation with USO price movement edging out the correlations with crude oil production and oil equity performance.

Buying at the peak and troughs of certain fundamental drivers elicit certain trends in USO performance and could be used to generate buy and sell signals.

Some of the most popular investing tools that have seen their volumes boosted during the oil glut are exchange traded funds based on energy commodity and equities. They range from accelerated leveraged based funds to securities that track the daily movements of just one spot price. Over the past two years, the oil and gas industries in the United States underwent incredible changes which had many different implications for fundamental changes in the markets there. As a result, exchange traded funds were used by investors as ways to hedge their portfolio against the trends that overtook the general stock market. Because change centered in the United States, the United States Oil Fund (NYSEARCA:USO) has been, perhaps, the most followed fund in the ETF market.

The United States Oil Fund, organized by United States Commodity Funds, was created to follow the intraday movements of the West Texas Intermediate spot price. In a more specific description by the company's website, USO's benchmark is "the near month crude oil futures contract trading on the New York Mercantile Exchange." The volatility of the futures price has caused above average volume in the trading of USO since December of 2014. In fact, 54 percent of the weeks in the period from the end of 2014 to now have generated volumes greater than one standard deviation from the average volume over the past seven and a half years.

The liquidity and activity of USO have enticed investors to try their hand at making a profit from it. With an optimistic recovery steadily developing, a bullish trend could provide the opportunity real soon. But how does one avoid blundering? In order to ensure that doesn't happen, one should look to some of the underlying fundamentals that drive the WTI spot price and the United States Oil Fund. In this statistical analysis, crude oil production, crude oil stockpiles, and the performance of crude oil equities will be reviewed as potential growth drivers. If a connection can be established between one of the fundamental metrics and USO growth, investors will be able to keep up with the trend and recognize when to time their trades so they can capitalize on the best opportunity for growth.

Crude oil production is one of the key drivers of the WTI spot price on a daily basis. The news of an increase in rig operation or an outage in a certain region (like Canada recently) can create dramatic shifts in the front month futures price. According to data from 2009 to now, a moderate negative correlation with a correlation coefficient of 0.495 is generated in a linear regression model for USO price and U.S. crude oil production. A scatterplot shows a two different clusters of points in the top left corner and the bottom right corner of the scatterplot. The distinction probably represents the effects of the oil glut which has pushed production very high which instigated a bearish, deflationary pressure on energy securities. For that reason, a better model to represent the data might exist in a logarithmic structure. Crude oil output doesn't weigh heavily on the price of USO unless it reaches extreme highs. For that reason, this fundamental metric might be unreliable in projecting the potential risk and reward in an investment in USO. Unless one can identify the point where price movement starts to intensify, planning a USO position on production is insensible.

Crude oil stockpiles are the ultimate measure of energy company's inventories during a given period. Measured weekly by the Energy Information Administration, this fundamental metric is watched just as closely as total production. The data for USO price and weekly stockpile data revealed a relatively strong negative correlation with a correlation coefficient of 0.714. While most of the points are clustered in the top right corner, successive increases in stocks have heeded relatively proportional changes in the price of USO. As a measure of inventory, the connection makes sense. When stocks drift higher, it shows that there is less demand or more supply in the market which would correspond to the necessary equilibrium shift. If stocks drop once again, demand has increased or supply has dropped, and once again, the equilibrium readjusts. The dynamic helps guide investors in their pricing of the WTI futures price as they shape their expectations based on supply and demand trends. So far, crude oil stockpiles appear to be the strongest driver of USO growth.

The XOI index is a ticker recorded by the NYSE Arca exchange which follows the performance of twenty of the top oil companies. Using its price, once can attempt to find a connection between oil equities and the USO exchange traded fund. Based on price data for both securities, a positive correlation with a correlation coefficient of 0.038. The weak connection suggests that there is very little predicting power in the analysis of these two securities. While USO tends to be higher when XOI is growing, each ticker tracks different entities which are joined solely by an industry. If anything, USO should lead the trend in oil and gas equities as it tracks the price of the main commodity that is bought and sold by the firms in question. Therefore, when prices are higher, those companies will prosper, but when USO drops, it may signal weakness in the oil and gas industry.

Before concluding that stockpile data are the best fundamental drivers for USO, a historical analysis should be conducted reviewing the performance of USO during trends in production, stockpile, and equities. The analysis has been split up for two different groups of data which showed differences in their results because of the differences in general investing environments. The results are interesting.

The first group analyzes USO performance after 2014 based on peaks and troughs in the fundamental drivers in question. Trends have been highlighted either green or red to illustrative the effect it should have on USO, either bullish or bearish respectively. After 2014, domestic production can be broken up into two different trends, one with a steep incline and another with a steep decline. Both saw USO be devalued by -41.5 percent despite the different supply effects that production has on spot prices. The identical performances could be explained by the failure of crude oil output to reach that "trigger" level when prices change exponentially (remember a logarithmic model might fit better for this correlation). When analyzed with trends in stock changes, the result was only slightly more helpful. The average price change of USO when stocks were in a downtrend was -16.95 percent while the average for an uptrend was -19.63 percent. The difference is minimal and provides no help for investors looking to invest in USO amidst volatility. The only metric that looked convincing was USO performance during trends in XOI. When oil equities were growing, USO grew 2.8 percent, and when oil equities fell, USO fell -72.6 percent. This trend and those involving stocks and production are most likely distorted by the overly pessimistic environment that weighed on the markets in late 2014 and 2015. As a result, investors may have felt the need to sell USO regardless of the fundamental patterns. Because the oil and gas trading mentality is starting to slow down and enter a smoother period, it may be worth looking at a similar time to find performance trends that are more evident.

Before 2014, the oil and gas industry was less controversial than the oversupplied fundamental position after 2014. For that reason, commodity investors focused more on fundamental metrics instead of pessimistic sentiment. In this period, production had entered into one clear uptrend which allowed only one avenue of analysis. Even though production grew during those 5 years, USO grew 4.3 percent. Once again, crude oil output is shown to be a weak predictor for USO price movement. There may be many reasons for that. For one thing, suppliers don't tend to shift their output too much to account for shifts in supply and demand. Thus, the metric alone doesn't provide much information regarding the state of the oil markets. Steep production growth could be attributed to a new technology (like fracking) and cause bearish pressure, or it could be a response to demand expansion which would result little to no shifts in the price equilibrium of the market. Once again, stockpiles provide us with the most interesting connection yet. Over the five years analyzed there were 11 different trends that went in either direction, providing plenty of evidence of its correlation with USO performance. USO investments made at the tops of downtrends in inventory and sold at the bottoms would score an average profit of 9.88 percent. Conversely, investments made at the bottom of uptrends and sold at the top would lose an average of -38.8 percent. In times of more logical trading, it appears that historical USO price change supports the idea that crude oil stockpile changes fuel USO trends. Nobody should be surprised though. Just as general manufacturing inventory trends are followed as major indicators of the supply and demand dynamics in the economy, so does crude oil stockpiles represent the supply and demand shifts in the domestic oil and gas industry. Analysis of the third metric shows another interesting connection between oil equities and USO performance. While one was seen in the volatile period after 2014, another stronger trend emerged in analysis before 2014. Less importance should be placed on these correlations because of tendency for USO and spot prices to lead XOI. Therefore, it would make sense that they move together, but it wouldn't make sense to use oil equities as a tool for timing.

Let's review. The USO exchange traded fund follows the daily movement of WTI spot prices and provides investors with an accessible hedge against oil price trends. Three fundamental metrics could play key roles in USO's performance if analysis shows a connection. While U.S. crude oil production correlated moderated with USO changes, its failure to communicate the dynamic supply and demand positions in the market makes it illogical as a timing device. Domestic crude oil stockpiles had a relatively strong correlation with USO and showed that during investment settings with minimal volatility, it can be a driver of USO performance. With uncertainty, the connection breaks down and emotional investing dilutes its ability to predict. The last fundamental metric, the health of oil equities, had almost no correlation with USO prices but showed a tendency to move with the oil ETF during its peaks and troughs. The strategy for USO trading? When the global economy is calm with minimal volatility in the commodity market, look to buy at the peaks if stockpiles and sell when they start to reverse upward. When there is volatility, a safer bet might be to watch for confirmation from oil equity trackers like XOI or the Energy Select Sector SPDR ETF (XLE) as their performance, alongside USO's performance, is likely to be similar. Using these strategies and the information provided above, investors wishing to trade USO will be able to create the best opportunities for profit. Although, it is also important to remember the limitations of historical analysis and the likelihood that these patterns may never repeat.

Supporting Documents

  1. USOAnalysis.xlsx

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.