SCO: More Supply Could Start To Weigh On Crude Prices

Summary

• Crude oil was a top performing asset class in 2021. As a result, investors in SCO were punished severely.
• Despite this backdrop, I think crude may be nearing a top, making short positions less risky now than they have been in recent past.
• Demand could slow in the winter months, due to Covid-variants. This is because travel demand may come down, driven by pandemic restrictions.
• OPEC+ continues to boost supply, and other developed nations are tapping SPRs to combat rising prices. This is bound to have some impact.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

imaginima/E+ via Getty Images

Main Thesis/Background

The purpose of this article is to discuss the ProShares UltraShort Bloomberg Crude Oil ETF (NYSEARCA:SCO) as an investment option at its current market price. SCO is a double short instrument, designed to return double the inverse of crude oil futures contracts. This is a fund I watch closely because, when oil seems overbought, it can provide investors with a way to earn an amplified return betting the other direction.

As I mentioned above, this fund has not offered much opportunity in 2021. I had been generally bullish on crude, as the momentum was clearly on the side of the bulls. Even as the price crept up in Q4, I still maintained an avoid rating on SCO, because I didn't think the pain was over yet. In hindsight, this was true, as SCO has continued to post losses. Worse, this comes at a time when the broader equity market keeps squeaking out gains:

Source: Seeking Alpha

As we begin 2022, I wanted to revisit this outlook. With the winter months in swing, pandemic-era restrictions resuming in Europe and some states in the U.S., and a general rise in oil production from OPEC+, I have begun to take a softening view on oil prices. In fact, it would not surprise me if prices start to drift south in the coming months. This offers some opportunity for positions in SCO at the moment. However, I would caution readers that I view this as a very speculative, short-term play. Due to the leveraged nature of the fund, this is not designed for a long-term holding. Further, I have a generally bullish-bias for crude over time. As a result, I think there is a window for some profit with SCO here, but it is one that should be attempted by those with a more risk-taking approach and who are willing and able to enter and exit trades quickly.

Oil's Rise Has Been Justified

To begin, I want to take a minute to discuss the broader story from 2021, which has been wildly positive for crude. While prices came under some pressure in early Q4, the trend for the calendar year was extremely bullish. Current prices sit near the top of the 1-year range, and the 1-year graphic shows a steady trend higher from last January:

Source: Bloomberg

This is important as it underscores why SCO has had such a bad year. Crude has been consistently rising higher. This means that any profitable positions in SCO would have been short-term and fleeting, so investors would have had to be very agile to have profited off net short positions.

Further, we should acknowledge that the gains for crude are certainly justified. There has been a rebound in demand as global economies have opened up since the worst of the pandemic. This has been coupled with the reality that crude production is still well below pre-Covid levels. This has caused consuming nations to dip in to their existing investors. This extends to the U.S., where we have seen crude holdings drop to historically low levels. Not surprisingly, this dynamic correlates very positively with rising prices, as the graphic below shows:

Source: Yahoo Finance

Now, this does not mean that crude can and will go up forever. There is bound to be some balancing of this dynamic. But I mention it because there is definitely positive momentum on the side of crude oil. This is why I emphasize that a short position in crude through SCO is not a sure thing, and is very risky. While I expect demand to ease and production to rise in 2022, those are not foregone conclusions. If one or both of those criteria do not develop, crude will rise, and that will make SCO a painful place to be.

OPEC+ Production Rising, Should Continue

With the disclaimer above taken care of, let us now examine some of the reasons why crude may be ready for a drop in the near term. One point in particular is the supply part of the equation. Pointedly, OPEC+ has been increasing production steady throughout 2021, albeit not at a pace that has kept up with demand. However, if we look to pre-Covid levels, we see that OPEC+ has plenty of room to increase production and still be within its normalized capacity range:

Source: S&P Global

This is critical to my point on buying SCO now, because I see a continued gradual increase from OPEC+ as very sustainable. The group has plenty of room to move on production, and they have already stated they will continue to add capacity in the new year. This makes me less bullish on crude since I see how much spare capacity they could add (based on pre-March 2020 levels).

As we start 2022, it is indeed likely that OPEC+ is going to go ahead with their pre-scheduled boost in January and February. Again, these gains are going to be measured and modest, but it adds on additional capacity that we have seen throughout 2021. In fact, according to a recent report from Bloomberg, the group is expected to announce another 400,000 barrels per day in production when they meet this upcoming week:

Source: Bloomberg

My thought here is that OPEC+ production is rising and, all other things being equal, that will keep a lid on prices. Of course, if production drops elsewhere, or demand rises faster than these increases (as we saw in the second half of 2021) then the impact may not be enough. But I will take each of those points in turn below, to show why a bear position in crude is not unrealistic.

Strategic Reserve Releases Materializing

Expanding on the supply issue, there are other developments that make me believe we will see enough supply to moderate prices near term. To be fair, OPEC+'s production increases are stable and pre-announced, so their impact on prices is not much in isolation. We have to consider the other factors at play - global demand and non-OPEC+ supply. With respect to other suppliers, we are seeing more production, but also a release of strategic reserves in a coordinated effort to combat rising prices.

While these moves are a bit ironic, given that many developed governments are advocating for a move away from fossil fuels (which is made easier by higher oil prices), it is exposing the political realities of consumer sentiment. Nobody enjoys paying more at the pump, American or otherwise. With the next election cycle always just around the corner, politicians tend to take action from keeping the price from rising too much. Given the current administration's low popularity, it is not surprising that they feel current prices have met this threshold.

To understand why this is important, look no further than the release of strategic oil reserves. This has been an on-going effort to contain prices and has occurred on more than one occasion. In fact, just recently Exxon Mobil (XOM) was awarded a loan from the strategic oil reserve, as reported by Bloomberg:

Source: Bloomberg

This is not enough in isolation of course. But a broader story emerges when we consider that other nations have been prompted by pressure from the U.S. to enact a similar measure. Most recently, South Korea also announced a release of oil from their strategic reserves, in an effort to placate U.S. officials:

Source: Arirang News (via YouTube)

My takeaway here is this is just another piece in the puzzle for potentially lower prices. In isolation, this moves are not very significant when we consider global oil demand on a daily basis. But if we couple this with softening demand and higher production from OPEC+, then a consistent pattern emerges.

Demand Has A Clouded Outlook

The final point in the equation is demand. For certain, 2021 saw a robust increase in global oil demand. While I see a boost in demand in 2022 as well, I don't expect that to happen right away. We are seeing renewed fears over Covid-variants, and my expectation is that will prove to be a short-term setback on travel and consumption. With oil prices near their 1-year peak, they seem ripe for a bit of a pullback with the omicron variant clouding the outlook.

To understand why, consider that many developed nations have reinstated curbs and restrictions on travel and outdoor activities. This is not just a U.S. phenomenon, with most of the new restrictions being implemented across Europe. In fact, just this past week, a host of countries announced new measures to combat the virus spread, with a sample of them of listed below:

Source: Euro News (Travel section)

My point is this will keep a lid on European consumption, if people are less likely (or not allowed) to gather and travel. Further, we are exiting the busy holiday travel season in the U.S., which is sure to lead to a drop in some air travel in the coming weeks. Compounding this, is that even during demand surges, airlines are having trouble keeping up with demand. The Covid-virus is not just hampering travel, it is also making supply of travel difficult. What I mean is, the virus is keeping workers out of work, whether it is airline staff or pilots. So even though demand is there, it is not all being realized.

For perspective, consider just how many flights were cancelled over the past holiday weekend, in a report from CNBC:

Source: CNBC

The conclusion I draw here is we are probably going to see demand soften in the coming weeks. Travel is probably going to ease, and airlines may not be able to accommodate all the demand anyway. Further, other important consuming trading blocs, such as the EU, are reinstating self-imposed lockdowns and restrictions to keep people from traveling and gathering. This will weigh on demand as well. While I see a longer term picture of global demand rising throughout 2022, I don't see that thesis playing out at the start of the year. This supports my bullish view on an inverse oil fund like SCO.

Bottom line

SCO has had a rough year, but I see light ahead in the first few weeks of the year. OPEC+ is expected to announce more production hikes, countries are releasing oil reserves on to the market, and demand will be stifled by Covid-restrictions. I do expect oil to stay in a fairly tight range in 2022, probably rising by year end. But, in the short-term, I see lower prices emerging as recent gains will be hard to sustain with this backdrop. Therefore, for those who can handle volatility and above-average risk, I would suggest giving SCO some consideration at this time.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of VDE, IXC either through stock ownership, options, or other derivatives. 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.

Comments

[JOHN KONG]

Is there any penalties or Cost of buying this and holding

[65wildcat]

Thank you for the article...

Has anyone traded large amounts of SCO, BOIL, or KOLD in an IRA, and had any trouble with UBTI on a K1 from these funds...

I have traded thousands of shares this year... hoping there are not any UBTI issues...

[Software Phil]

Others are saying oil will be 100-120 in 2022... And I agree, that no one is listening to government restrictions anymore... So everyone is traveling and getting together - back to normal type life style... So, oil will be volatile, but it is used for creating so many products - rubber, plastics, lubricants, fuel - and where is plastic used in? everything!

[n00binvest19]

Two flaws.
One
No one is listening to government restrictions anymore and there is no more stimulus to entice people to stay home.
Two

There is little spare capacity left until significant investment happens.