Contango And The Increasing Oil Glut Will Continue To Punish USO

Apr. 30, 2020 10:04 PM ETThe United States Oil ETF, LP (USO)43 Comments
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Summary

  • Limited storage will push oil negative as investors scramble for storage.
  • Large amounts of retail investors have created a disconnect between the price and NAV.
  • Even if states begin to reopen, supply will continue to outpace demand further extenuating storage issues.

Intro

With limited storage spaces plaguing oil investors, a retracement of West Texas Intermediate (WTI) to negative prices is completely reasonable given the current economic outlook. This is important because the United States Oil Fund (NYSEARCA:USO) operates by purchasing WTI futures contracts and not the physical oil, so the June contract going negative could severely impact the already depressed price of USO.

In this article I will explain why I believe the June contract could trade as low as -$50/ barrel weeks before the expiration date, how a decrease in storage will keep prices low, and how an influx of retail investors creates a prime opportunity for USO to decrease significantly.

Storage Concerns

Fueling the May contract of WTI to fall as low as -$40 were concerns that there are no viable storage options. Cushing, Oklahoma, the location CME oil futures are delivered, currently has 53 million barrels in storage with only 23 million barrels of storage left. This may sound reasonable, but all 76 million barrels of storage are under contract for future deliveries. This means that the Cushing location is no longer a viable option for traders to store oil and was the driving factor for negative oil prices come expiration day.

So why is this important? USO holds a significant number of futures contracts with listed dates of when it will begin to sell its contracts. For June, it will begin rolling over these contracts between May 1st and May 14th. Although it is changing its investment structure to further dated contracts, near-zero or negative prices in the near-term contracts will wipe out a large percentage of USO’s share price.

Source: USO

Its current structure can be seen above with:

14% in June

14% in July

16% in August

16% in September

10% in October

10% in December

On April 21st, when USO announced it would begin to change its structure, the June contract took a dive trading at lows of $6.45. I believe reaching these levels pre-rollover is completely feasible and could trade much lower as investors do not want to be stuck with the burden of having to find a location to store oil.

If the June contract does turn negative, we can do some back-of-the-napkin math to determine how much this would impact USO.

Source: Author using data from USO

So, even an investor who believes in the long-term potential of oil and is trying to find a vehicle for investing in this commodity could sustain a massive loss by one contract going deep in the red prior to the rollover date. These calculations just take into account the June contract and represent a loss sustained to the entire oil fund if crude oil plunges. If the June contract plunges, there is a very good chance that the July, August, September, and even October contracts decrease in value making it much more feasible for USO to go to $0.00 way before the June contract reaches -$50.

Now, obviously -$50 seems like an extremely pessimistic outlook on the oil market but with storage shortages and a surplus of nearly 10-20 million barrels/day entering the market, it is entirely feasible. Compare this with people who are even calling for -$100/ barrel and -$50/ barrel sounds like a rosy outcome. I believe that these storage concerns will persist and a significant increase in demand will not be sustained even if states start to open up their economies. With this, negative oil prices prior to the rollover seem very reasonable. If you would like to read more in-depth on the lack of supply options, last week I detailed a play on oil tankers that are poised to take advantage of this very issue.

Premium to NAV

With all this negative news surrounding oil, I would have a hard time believing that USO is trading at a premium to its NAV, but it is. Almost trading 5.5% higher than the underlying oil contracts because of a recent influx of retail investors. Some have even called it the Robinhood effect. Looking at this chart below represents the full scope of how many retail investors have jumped on the USO train, hoping oil will go higher in the future without understanding the actual product they are purchasing. They have a “buy the dip” mentality, but this thought process could completely wipe out their entire position.

Source: Robintrack

Jim Cramer even quipped that large funds are going to take advantage of these retail investors, stating, “There are times in life when people know that there’s an instrument that is faulty, and they can shoot against that instrument and bury these people.” This statement is essentially conveying that due to the naivety of retail investors, hedge funds will ruin these investors who do not properly understand the product they are trading.

Even the Put/Call Ratio, which is used to determine the sentiment of a security, is only 1.08. This represents that the general consensus isn’t overly bearish causing option premiums to be quite reasonable given the circumstances of high implied volatility.

Bullish Case for USO

Even though I firmly believe that the oversupply and storage issues will decimate the USO fund, this fund does have a disconnect from reality. I believe this can be seen with USO trading at a premium to its NAV, given the severely bearish environment oil is currently in. With this, further developments in the economy regarding a vaccine for the virus or states opening their economies could push oil higher. Especially with USO beginning to put more weight in longer-dated contracts, it just takes the market to perceive oil will increase in price for the contracts to increase in value. With this said, I believe oil has been a very reliable indicator for the economy and does not react to headline news in the same regard as the stock market.

For example, when Remdesivir was claimed as the miracle drug solution to the virus, oil continued to fall while the S&P 500 opened over 3% on a baseless claim. I believe for oil to move higher, it will take empirical evidence of the economy returning back to normal levels of oil usage to have a sustained move higher.

Conclusion

With next to no storage available on land and dwindling oil storage at sea, oil prices will continue to fall as nobody is able to take delivery of the formerly known “black gold.” If June contract prices are to fall to the May contract lows before USO rolls them over, the fund has a very real possibility of going to zero. For this trade, I would recommend either purchasing put options or selling any shares you might currently own as any long investor will most likely be punished for trying to make a seemingly prudent move. Know what you are trading, how it moves, and don’t get “buried” by big money.

This article was written by

RJW Insights profile picture
425 Followers
The focus of this page is to find esoteric investment ideas and view them with a unique perspective. Applying information learned from working in the finance industry, I believe a salient point of view regarding value and a long-term perspective will help assist in finding mispriced equities with massive growth potential.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in USO over 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.

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