Over the last month, the United States Oil ETF (USO) has fallen by nearly 12% in a decline which has reached some of the lowest prices since the start of the year. In this article, I will dig into the fundamentals behind the ETF and show why we are likely to see further price declines in USO.
This Year in Review
Let’s start with a discussion of historical fundamentals throughout this year to frame up the current environment in which we find ourselves. I’ve attached some labels to the following chart with some commentary below as per what drove price over the last few months in crude oil futures.
Throughout this year, there have really been two major themes driving the fundamental balance of crude oil. We started the year with a period of undersupply in that refineries were processing near-record amounts of crude oil on the wings of substantial OPEC cuts which took effect at the beginning of the year. By April, problems began to develop in the product markets in that gasoline stocks were substantially oversupplied and refineries essentially were forced to taper back runs or destroy margins.
These cuts would have been bearish for crude oil in that the largest source of demand has been very weak this year (starting around April); however, imports have essentially been the saving grace of crude markets through April. Beginning in late April however, imports resumed in force and refining demand has been lackluster.
This fundamental situation of oversupply has been in force since late April, and since then the price of crude has fallen by nearly 20%. What is particularly troubling about the current oversupply situation is that this comes in the midst of ongoing sanctions and production cuts. In other words, even with a host of variables which should impact the flow of crude oil, the United States remains well supplied and is likely to continue to be so. Given this current dynamic, OPEC’s hand is essentially forced in that it must maintain cuts or risk substantial downside in crude pricing. Yes, the fundamentals for crude oil are very bearish right now and unless we see a very strong driving season in the United States (which doesn’t appear to be the case), we are likely to see the crude balance continue to weaken against the 5-year average and see prices continue to fall. Last week’s reported build of nearly 7 million barrels is a canary in the coal mine for any remaining bulls out there: there simply isn’t enough demand to keep up with the United States supply.
Investors in USO have another punch headed their way in the form of strengthening contango in the front contracts. USO follows a rolling schedule in which during a certain window it rolls futures' exposure from one month to the next month prior to contract expiry. This results in something called “roll yield” which is the return attributed to the tendency for back-month futures contracts to drift towards the front-month futures contract as the month progresses. When the market is caught in contango (as it is now and a sign of an oversupplied market), roll yield will be negative as long positions established in the back of the curve drift towards the front-month position. As you can see in the following chart, the structure is showing greater weakness as the bear-trend steepens which will result in greater losses for holders of USO as long as the market remains in this state.
No fundamentals exist in isolation and to get a holistic view of the market, we should factor in the technical landscape as well. The chart for WTI is basically in a free fall and is giving the message “look out below.”
The current trend is without a question down. The trend in place since the beginning part of the year was ended with finality in May as price crashed through the ascending trend line and rolled over into a downtrend. The market gave one attempt through mid-May at a bounce towards new highs but price rejected the attempt and rapid and strong selling commenced. To tie price to fundamentals, this is the period of time in which imports settled back into the 5-year range following the multi-month historic weakness and refining demand continued to hover near the bottom of the 5-year range.
The current downtrend technically started in mid-May as the prolonged pullback broke and price sold off rapidly. We are currently in a weak pullback in the existing trend with price testing the established descending trend line. If you’re not familiar with technical analysis speak, this basically means that now is a pretty good time to short because markets tend to move in periods of with-trend/against-trend strength generally bound by levels of support and resistance. Price is currently immediately at resistance, which means that we are likely to see another bout of with-trend strength with a strong potential for new lows in the trend. Today was very telling in WTI futures in that what started as a slightly positive day turned quickly negative and market structure widened into a deeper contango in one of the largest moves seen in several weeks. In other words, the oversupply situation is likely to continue and shooting for lower prices is the highest probability trade.
The current fundamental picture is one of bearishness which is unlikely to let up for some time. OPEC supplies were one of the primary saving graces of crude oil this year and in recent weeks the effects of OPEC cuts have worn off as the U.S. is sourcing other barrels. The technical factors are strongly bearish with immediate resistance providing catalyst for fresh short positions with the primary trend. It’s a great time to short crude oil.
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.