Oil ETFs Surge As 'Rubber Band Snaps'

April 11, 2019

Stocks have been getting all the headlines this year, and rightfully so. The S&P 500’s best start to a year in two decades is certainly worthy of attention. But lost in the commotion about stocks is another key asset—oil—which is also seeing its best start to a year in a long time.

WTI crude oil prices (the U.S. benchmark) surged 32.4% during the first quarter, good enough for the best Q1 since 2002—and the rally hasn’t let up. As of April 9, crude oil increased its year-to-date gains to 41.2% as West Texas Intermediate prices neared $65 per barrel.

Thanks to crude’s ascent, oil-tracking exchange-traded funds are among this year’s best-performing ETFs. That includes the $1.6 billion United States Oil Fund (USO), up 38%, and the $391 million VelocityShares 3x Long Crude Oil ETN (UWT), up a whopping 144.3%.

Sentiment Reversal

There are a number of reasons for crude oil’s sudden good fortune, not the least of which is the fact that prices tumbled last year. WTI lost about a quarter of its value in 2018, falling from a high of more than $76 in October to a low of $42 in December.

A lot of this year’s rally is merely a case of the rubber band stretching too far in one direction and then snapping back quickly. Oil, like stocks, recovered, as traders realized the global economy may not be in as bad shape as many had feared.

An anticipated resolution of the U.S.-China trade war and easier monetary policy in the U.S. were instrumental in turning sentiment around.

 

WTI Crude Oil Prices

 

Libya Civil Strife

But it’s not just a sentiment-driven rally in crude oil. Lately, supply concerns have been popping up, such as those related to Libya’s oil production. Violence in the North African nation has periodically disrupted production since the overthrow of former ruler Gaddafi in 2011, and renewed skirmishes threaten to halt output once again.

Khalifa Haftar, leader of the Libyan National Army, has promised to take over the capital city of Tripoli, while the internationally recognized government head Prime Minister Fayez al-Sarraj has vowed to resist his advances.

While Libya’s oil fields—most of which are under the control of Haftar—are unlikely to be affected by fighting in Tripoli, they could be if the conflict spreads in the country.

Currently, Libyan oil output stands at 1.1 million barrels per day, close to recent highs. But it’s fallen as low as 200,000 barrels per day when fighting picks up.

OPEC Cuts

The Libyan supply jitters come on top of a backdrop of tightening OPEC production. The cartel and its allies agreed to slash their output by 1.2 million barrels per day starting in January. Those cuts—which currently have a 92% compliance rate, according to the International Energy Agency—are scheduled to last through June and then may be extended through the end of the year if members agree.

In addition to coordinated OPEC cuts, traders are nervous about involuntary cuts by some members. Venezuela’s oil production, for example, is on a straight path lower due to a full-blown economic crisis in the country and lack of investment. Venezuela’s oil production tumbled to less than 900,000 barrels per day in March, 40% below year-ago levels.

Meanwhile, traders are anxiously awaiting news on whether the Trump administration will extend waivers for eight countries to continue importing Iranian crude oil in light of U.S. sanctions on Iran. If they are extended as expected, Iranian oil supply should be stable. If they’re not, look for exports out of the country to dive, tightening the global market.

US Oil Boom Going Strong

With so many supply issues coming to the fore, it’s easy to get carried away with the bullish case for oil prices. But that enthusiasm should be tempered by the relentless climb in U.S. crude production, which stands at an all-time high of 12.2 million barrels per day.

Up a whopping 1.8 million barrels per day from where they were a year ago, there’s little reason to expect U.S. oil supplies will slow any time soon, especially with prices making a comeback.

That creates a relatively balanced outlook for oil: Healthy demand and bubbling supply disruptions on the one hand and booming U.S. production on the other.

 

US Oil Production

 

Better Bet?

USO, UWT and other oil-tracking ETFs may have more room to run, but don’t expect the climb from here to be as swift as the rebound from December’s lows.

Indeed, regardless of what oil prices do from here, a case can be made that ETFs tied to energy stocks, like the $14 billion Energy Select Sector SPDR Fund (XLE) or the $2.3 billion SPDR S&P Oil & Gas Exploration & Production ETF (XOP) are the better bet.

According to Nicholas Colas, co-founder of DataTrek Research, energy stocks’ weighting in the S&P 500 is a mere 5.4%, well below its average level of around 10%.

A bounce back in energy stocks to a more “average” weighting could propel those ETFs higher.

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

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