USO: When Oil Titans Clash, We Mortals Step Aside

Summary

• Crude prices recently experienced one of the largest changes ever reported as OPEC policy has essentially collapsed.
• For the past few quarters my bias has been bullish due to production growth slowing as well as OPEC cuts remaining in place.
• Due to the massive change in OPEC’s policy and approach, we must reassess our balances and at best maintain a neutral bias.

With the price of crude oil falling by around 50% on a year-to-date basis, shareholders in the United States Oil Fund (NYSEARCA:USO) have taken a beating as both supply and demand factors have strongly impacted the balance. In the following analysis, I detail why I believe now is a good time to stand aside from the crude markets and that for the next few weeks a neutral position on oil is likely the safest bet.

Crude Fundamentals

If you’ve been reading my articles for some time, you’re likely aware that I’ve been an oil bull for several quarters. The underlying reason for this bullishness rested primarily on two key supply variables: slowing production and OPEC cuts. Over the last 72 hours, however, there has been a substantial change along the OPEC front which has led to one of the largest daily declines in the price of oil ever recorded. Due to this incredible change in fundamentals, we are forced to reassess our supply and demand balance to make sure that it’s reflecting the latest information.

As previously mentioned, there were two variables driving my bullishness. The first of these was slowing production growth.

This variable very much remains a bullish piece of the crude balance. The underlying story here is that there has been a slew of bankruptcies across the productive crude regions. These bankruptcies have led to a slowdown in drilling activity as well as plummeting production growth rates across the regions.

The reason why this factor remains bullish is that even in a troubled economic environment, base crude demand increases in most years due to simple things like population growth or increased economic activity. This means that crude production must grow at an equivalent rate (or greater) or you will have shortages and the price of crude will rise.

What this essentially means is that as long as the current trend in place continues, the odds of a price rally increases through time. In other words, since demand is growing and supply is contracting, at some point inventories will decline and the price of crude will rally.

However, there is another piece of the balance: imports. Since the start of 2019, we have seen imports at multi-year lows as OPEC constrained barrels into the United States through its production cuts.

This all changed this weekend though as OPEC and Russia ended a 3-year pact in acrimony. The short version of the story here is that since 2016, Russia and OPEC have coordinated actions so as to increase the price of oil during selloffs. This has served as a good global balancing mechanism in that it has allowed OPEC to manage price declines in the face of growing crude exports from the United States as the shale industry has stretched its wings.

Over the last week, OPEC met to discuss furthering its set of cuts. During the meeting, however, Russia would not agree with extending cuts and the meeting ended without an accord reached – resulting in a 10% drop in the price of crude on Friday. However, over the weekend, Saudi Arabia decided to flex its muscles and cut its selling prices of crude oil in an attempt to capture market share. This resulted in crude falling by the greatest magnitude seen in decades with the Friday to Monday price change clocking in at a drop of around $10 per barrel.

At present, the titans of the oil market are clashing. That is, the second-most productive crude player (Saudi Arabia) is now in a price war with the third-most productive player (Russia). And these two participants represent around 23% of total world demand. When the titans clash, the only prudent course of action for mortals is to stand aside until the dust begins to settle. In other words, we are currently in a fog of war situation in which we don’t know if this is gamesmanship to bring Russia back to the negotiation table or if this is a multi-month trend in which Saudi Arabia once again tries to take down the U.S. shale. Given this uncertainty, it makes sense to stand aside until there is more clarity on OPEC’s policy.

If Russia indicates a willingness to negotiate, we should likely switch our bias to be bullish. If no communication happens, however, we should remain neutral until U.S. shale producers begin to capitulate in force – at which point we should switch our bias to be bullish. Until then, since the titans are clashing, we mortals should stand aside.

About USO

Prior to moving on, we need to say a quick word about USO and its methodology for this trading environment. USO’s methodology is fairly simple in that it holds the front month of WTI futures and then two weeks before expiry, it shifts exposure into the second-month contract. This simple methodology has a bit of a problem for long traders in that it is heavily exposed to roll yield.

The basic idea behind roll yield is that “futures converge toward spot.” What this tangibly means is that if you’re holding exposure along a futures curve, you’re going to make or lose a gradual return when your futures contract gradually moves towards the prompt price of the commodity. Depending on market structure, this return will be either positive or negative.

With the recent crash in crude oil, we have seen the forward curve shift heavily into contango.

What this means is that USO is currently holding and rolling exposure across contracts which increase in value along the curve. Since futures converge towards spot, this means that these back-month holdings will be declining in value in relationship to the spot as time progresses. This means that roll yield is negative for the ETF and inventors looking to buy it need to be warned of the gradual losses which will accrue against holdings in the fund.

Conclusion

Crude prices recently experienced one of the largest changes ever reported as OPEC policy has essentially collapsed. For the past few quarters my bias has been bullish due to production growth slowing as well as OPEC cuts remaining in place. Due to the massive change in OPEC’s policy and approach, we must reassess our balances and at best maintain a neutral bias.

Analyst’s 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.