Oil ETFs For The Coming Rebound

April 01, 2020

There aren’t enough superlatives to describe how bad things are for the oil market right now. The sudden, rapid spread of coronavirus around the world, and a production surge from Saudi Arabia, have combined to send crude oil prices into a tailspin.

On Monday, prices for West Texas Intermediate (WTI) crude oil, the U.S. benchmark, fell below $20/barrel for the first time in 19 years, as traders grappled with the largest oil glut in modern history while demand wanes with the economic shutdown.

The United States Oil Fund (USO), which tracks oil futures, has fallen 67% year to date, while the Energy Select Sector SPDR Fund (XLE), which holds energy equities, fell by 53% in the same period.

WTI Crude Oil Prices

 

Unprecedented Glut

Falling demand and rising supply is never a good recipe for oil, but the current level of oversupply is unheard of. As economies around the world come to a standstill, demand in April may plummet by 15 to 22 million barrels per day, according to a survey of analysts by Bloomberg.

Meanwhile, supply could increase by 2 to 3 million barrels per day—most of it from Saudi Arabia—as the Kingdom follows through on its threat to pump full throttle.

For context, during the worst quarter of the financial crisis 11 years ago, demand fell by 2.5 million barrels per day; and that was while OPEC trimmed output by 4.2 million barrels per day to support the market.

The current situation, where demand is falling by many multiples of what it did during the Great Recession, at the same time that supply is surging, simply has no parallels. In fact, the glut is so great that some analysts are suggesting that all available storage capacity could be filled up, leaving nowhere for excess crude oil to be stored.

If that happens, prices could fall even more precipitously—into the teens, below $10, and even zero are values that have been thrown around.

Indeed, some grades of crude are already trading at once-unimaginable levels. West Canada Select, for example, was trading at $5.08 on Tuesday, while Guernsey Light Sweet traded at $8.48. These landlocked crudes have limited buyers, so they are trading at hefty discounts to WTI.

Shut-Ins Coming

At some point, crude oil prices will get so low that producers will be forced to shut in production. Analysts at Rystad Energy forecast that output will have to be reduced by 3 million to 4 million barrels per day to prevent storage from filling up.

“The current supply/demand gap adds up to a first half 2020 surplus of 1.8 billion barrels. That exceeds the upper end of our estimate of available crude oil storage capacity, which is 1.6 billion. Production is going to have to be reduced or even shut in. It is now a matter of where and by how much,” said Jim Burkhard, vice president and head of oil markets at IHS Markit.

According to IHS Markit, producers will be hesitant to shut in their production for purely economic reasons because there are risks to shutting in production, such as reservoir damage.

Still, if there is nowhere for the oil to go, output will have to be reduced; it’s just a matter of when and how low prices have to go to incentivize that.

Bloomberg reported last week that prices for Wyoming Asphalt Sour had fallen into negative territory, meaning that producers had to pay to get someone to take the oil off their hands.

Medium Term Brighter

Short-term shut-ins may be what balances the oil market, but those wells should come online relatively quickly once prices recover—which they will. Eventually, demand will rebound as people start leaving their houses, driving and flying on airplanes.

This brutal downturn in oil prices will also take its toll on the supply side. Investment in new wells is poised to fall dramatically, in the U.S. and elsewhere, reducing supply growth down the line.

All that should lead to a healthier oil market in the medium term. However, longer term, oil still faces challenges in an increasingly climate-conscious world, but that is not an immediate concern.

Pitfalls Of Oil ETFs

It’s fair to say that at some point in the next few years, oil prices will be back over $40 at least—double from here. Investors may look at that and see a juicy opportunity to double their money, but it’s not that easy.

ETFs are some of the best tools to get exposure to oil and the broader energy space, but even with them, there are many pitfalls that investors face.

For one, it’s not possible to get one-for-one exposure to spot oil prices. Even if you had access to storage tanks and could hold oil there for a couple of years, it would be exceedingly expensive in the current environment, when capacity is so scarce.

In an ETF wrapper, the closest thing to that are funds that hold oil futures, such as the United States Oil Fund LP (USO), but they face a similar dilemma. Futures contracts must be rolled from month to month, leading to substantial roll costs. Those roll costs are even higher than normal today, a reflection of the premium cost of storing physical barrels.

For example, as of this writing, crude oil for June delivery was trading at a whopping 20% premium to crude oil for May delivery. Rolling from the May to the June contract would net you 20% fewer contracts in just one month.

That’s why an investor cannot simply buy USO today with oil at $20 and expect to generate a return of 100% if and when oil prices go back to $40. Actual returns will be dramatically less than that.

Moreover, if oil prices continue to slide in the short term, USO could tumble much further from here before it rebounds, leading to steep losses that will be difficult or nearly impossible to make up.

An Alternative

Year to date, investors have plowed a stunning $2.8 billion into USO. Many of those investors are already under water—the fund’s current assets only total $2.3 billion. It wouldn’t be surprising to see more investors dip into the fund as they try to catch the falling oil knife—they should just be aware of the substantial risks facing the ETF. They can also consider alternatives to USO.

For investors intent on investing in oil itself, a viable alternative to USO is the United States 12 Month Oil Fund LP (USL), which tracks the 12-nearest-month that oil futures tracks. It is still susceptible to roll costs, but only has to roll one-twelfth of its position each month, significantly reducing the drag from those costs.

On the flip side, because it holds 12 contracts, it is less sensitive to fluctuations in spot oil prices—both on the upside and downside. For example, today’s May 2021 oil futures were trading at $34, compared with $20 for May 2020 futures; any lift in oil prices will benefit those later-dated futures to a lesser extent than front-month futures.

Equity ETFs A Better Option

For investors with a longer time horizon, the best way to play an oil rebound may be through energy equity ETFs. These funds don’t have to contend with roll costs; they are diversified and their expense ratios are generally low.

Still, energy equities are not without risk. Many energy companies are highly leveraged and may be unable to repay their debts in the current environment. Bankruptcies will likely be numerous and the industry will have to deal with a period of downsizing and consolidation.

That’s why funds that have greater exposure to large, integrated oil companies like the Energy Select Sector SPDR Fund (XLE) may be a better bet than funds that focus on smaller, independent exploration and production companies, like the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).

With half its portfolio in Exxon and Chevron, XLE is down 53% this year compared with 67% for XOP.

 

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

 

Another fund to consider is the VanEck Vectors Oil Refiners ETF (CRAK), which exclusively holds stocks of the companies that turn oil into refined products like gasoline, diesel, jet fuel and heating oil.

Like producers, refiners are struggling today as demand for petroleum products plummets. But once economies come back to life, refiners may be among the first to benefit when pent-up demand for travel and leisure is unleashed.

Refiners make money on the spread between crude oil and refined product prices, so they are less concerned about the absolute price of oil, which is a plus if crude stays depressed for a while.

CRAK currently has a year-to-date loss of 43%.

YTD Returns For XLE, XOP, CRAK

Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2

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