USO: More Upside Remains

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About: The United States Oil ETF, LP (USO)
by: QuandaryFX
Summary

USO is currently in the middle of its rolling process which means that roll yield will drive a larger share of returns going forward.

Roll yield is currently positive with the market caught in backwardation in the front two contracts.

The fundamental picture is strongly bullish with imports likely to be constrained through March of 2020.

As seen in the momentum table from Seeking Alpha, shares of the United States Oil ETF (USO) seem to have finally caught a bid with prices up in most time frames for this year.

In this article, I will explore the drivers of exactly why prices are rising as well as make the case for further upside. If you’re on the sidelines in the crude trade, I believe now is an excellent time to buy USO.

The Instrument

To start this off, let’s have a discussion on exactly what USO is and why an understanding of its methodology matters. Put simply, USO is one of the most simple and straightforward ETFs which tracks crude oil but that doesn’t necessarily mean that if you hold it over long periods of time you will gain the return of the price per barrel. On the contrary, due to a few key ramifications of its methodology, long-run returns of the instrument often fall short of the actual underlying return of WTI futures. But I’m getting ahead of myself – let’s talk about what USO is.

USO is an ETF which gives exposure to WTI futures contracts. At present, it is holding over 17,000 contracts of October futures and around 6,000 contracts of November futures as seen in its holdings table.

The reason why USO is holding positions across two separate months is that we are currently in its rolling window for shifting exposure from October to November. This process happens every month at roughly 2 weeks before contract expiry and results in some interesting returns for the instrument.

In financial markets, there’s a persistent feature in futures markets: contracts in later months tend to trade towards the front of the curve as time progresses. This relationship can be graphically seen in this chart from Wikipedia and has implications for strategies exposed across a futures curve.

https://upload.wikimedia.org/wikipedia/commons/thumb/0/0b/Contangobackwardation.png/1024px-Contangobackwardation.png

When a market is in contango (front contract below back contracts), roll yield on a long position will be negative because the long position established at higher prices tends to trade down in value towards the front-month contract as time progresses. Conversely, when a market is in backwardation (front contract over back month contracts), roll yield on a long position will be positive since the long contracts established at lower prices will tend to trade up in relation to the front-month contract as time progresses.

Since USO is currently in its rolling period, this means that over the next few days the exposure will be shifted to November futures and roll yield will be in effect (until October futures expire and November becomes the prompt). The effects of roll yield on the long-term returns of USO can be seen in the following table.

That’s right, USO has largely underperformed the price of WTI in most years over the last decade. In some years, underperformance has been in the range of several dozen percentage points. The reason for this underperformance is the fact that over the past decade, WTI futures have been in contango in about 78% of all months in the front two contracts. Since USO rolls exposure across just the front two contracts, this means that roll yield has been negative (and a constant drag on performance) for almost all periods over the last decade. However, a glance at the current forward curve should bring good news for the USO longs: we’re in backwardation.

Numerically speaking, we are currently at about 10 cents per barrel of backwardation in the front. This means that since USO is shifting exposure into November futures, roll yield will progressively become a stronger driver of returns in the instrument during the rolling window and roll yield will be more and more positive. Since November futures are priced lower than October futures, price will tend to trade up as time progresses (until November becomes prompt once October expires) bringing generally positive (or less negative) returns to the holders of the ETF versus prompt futures. This in and of itself could be a strong reason to hold USO, but the fundamentals of crude oil are strongly bullish right now as seen in the following section.

Fundamentals

Rather than performing a deep dive of every fundamental factor at work right now in the crude markets, we can take some pretty large strokes to see the big picture. First and foremost, the year-to-date balance in crude oil shows that we are in one of the largest draws ever seen for this time of year.

The current year-to-date draw of around 20 million barrels has only been rivaled by the last two years – and in each of these years prices were either strongly rising or rallied for the next several months following the draw.

Another way of looking at the data is the 5-year range of inventories and for the first time in several months, we are basically at the 5-year average and the trend in inventories will likely see us strongly under the average within the next month.

The reason why this matters is that there is a direct correlation between the price of crude oil and the level of inventories versus the 5-year average. As inventories fall below average, it signals that supply is unable to keep up with demand and prices tend to rise as seen in the following chart.

This relationship is fairly persistent in the data, but the real question is this: will inventories keep falling? My answer is a pretty firm “yes.” The reason I say this is that the primary reason that inventories are falling is OPEC and OPEC is staying the course.

Specifically, at the beginning of this year, OPEC began cutting exports. This decision from OPEC led to an immediate uptrend in the price of crude. This price rally stalled around the middle of the year and then OPEC decided to extend its cuts through at least March of 2020. You can quantify the impacts of their decision in many different ways, but the basic message is that crude imports into the United States on a year-to-date basis are some of the lowest seen in several decades.

And on a weekly basis, imports have consistently come in below the 5-year range in almost every week.

This relation of constrained supply is likely to continue through March of 2020 (if OPEC can control itself) which means that supply will continue to be hampered. As long as supply is hampered, prices will likely generally rise. When you couple this with the roll yield factors for USO, it makes holding the ETF a solid choice for at least the next several months. It’s time to buy USO.

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.