Disclosure: The author is not a financial advisor, does not provide financial advice, and aims to present facts and an objective measurement on the topic. Some posts may be speculative or present the author's opinion and should not be interpreted as investment advice.

Background

Oil and energy ($XLE) have been S&P laggards for the past few years. I’m not a huge fan of this sector as I do believe electric cars are the way of the future, but there is certainly an opportunity here.

Admittedly, I tried timing this twice in 2020, once in January before the COVID-19 market crash and once in March/April Trump pumps and OPEC+ meeting. Both times ended up being a gamble with poor results. The strategy was to go into $USO leaps dated for 2021/2022 while shorting the underlying short-term /CL futures contracts as a hedge and to take advantage of the short-term pain. For a short while I was also long $XOM which had exposure to both the commodity and a positive covariance with the S&P (not to mention a terrific bidding war between Buffett and Icahn). While I dampened by losses with the futures contracts, $USO would spike on the news and immediately sell off. This is incredible weakness and at some point I decided I won’t touch anything oil-related until demand returns and sticks.

Bloomberg $USO record inflows U.S. Oil Fund ETF experiences record inflows. Source: Bloomberg News1

Eventually in late April, $USO came on everyone’s radar as the May /CL contract hit negative price per barrel and became frontpage news on CNBC. Prices turned negative because no one wanted barrels of sweet crude showing up at their door so they were paying others to take the oil from them. The culprit here is primarily retail investors who decided to buy the /CL futures contracts outright, not ETFs like $USO which had already rolled out their contracts. Retail traders and Financial Twitter #FinTwit poured in with $USO puts (myself included). That day/week made oil history with negative oil contracts (not just negative prices in fringe landlocked U.S. states), tankers filling to the brim and not accepting any more storage, and several oil ETFs and leveraged ETFs going bust

Is the bottom here?

Possibly. It’s impossible to tell. This could be the bottom and as the U.S. and the rest of the world opens, demand will return. The world might also face a COVID-19 relapse in the Fall and shut down again, causing oil prices to collapse again. Oil might simply just go down more.

As Jim Rogers stated in his book, Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market, commodities go through these boom and bust cycles where commodities rise and fall, and with them, producers open or close mines/wells. This takes time. In our case, as oil falls, we will expect more bankrupties (as of the writing of this article several have already occurred), leaving the world with fewer WTI Crude Oil producers. When demand returns, these small number of producers will control more of the market and will be more valuable when price rebounds. Eventually, they will build more wells and the cycle repeats.

However, investors thinking in the 3+ year timeframe would probably agree that the current oil prices are absolutely not sustainable to most (if not all) oil-producing countries (most notably the Kingdom of Saudi Arabia $KSA and Russia $OGZPY). Not to mention the United States has already pledged to save American oil producers.

How can we profit from this?

One can simply wait for the economy/world to reopen buy the $USO ETF and hold for 3+ years. This is certainly a viable strategy at this point, but takes a bit of research, attention, and timing. A lot of investors don’t have the patience and would rather jump from one shiny trade to the next. In this case, I would consider buying the $USO ETF and selling ITM (in the money) covered calls dating out to this summer/fall to lock in premium. Alternatively, as I mentioned previously, one could go long the commodity producers ($XOM, $OXY, $BP, $XLE) which will rise along with the S&P to reduce exposure to the underlying commodity. I would want for a few more bankruptcies before dipping my toe in, like what happened with Whiting Petroleum Corporation ($WLL). The time is almost here, as nations and states are reopening and governments (like the U.S. government) and OPEC+ are beginning to take drastic measure to save oil prices.

Another interesting trade I’ve seen floated is shorting banks with significant oil exposure, especially as banks are setting up dummy corporations to wholly own oil production assets from failing producers. This includes Bank of America $BAC and Citi Group $C. Banks as a sector (^BKX, and also $XLF) exhibit significant weaknesses in this climate and this trade could be profitable in multiple ways. This could be an excellent pair trade if you are long S&P (SPX, SPY) or (eventually) long $XLE.


References

  1. https://www.bloomberg.com/news/articles/2020-04-21/u-s-oil-fund-issued-all-registered-shares-awaits-sec-approval