Volatility Returns To Oil ETFs

September 11, 2020

It was bound to end. After two months of unusually placid oil prices, the commodity tumbled this week.

Brent crude oil prices were last trading around $40 after hovering between $42 and $46 during July, August and the first week of September.

WTI crude oil prices, which largely traded between $40 and $43 during the same period, sagged to $37.

As crude oil prices dropped, the Cboe Crude Oil Volatility Index, the “VIX of the oil market,” spiked from around 32 to 56—a high level, though nowhere near the peak of 325 reached in April, when WTI oil prices briefly fell into negative territory.

Brent Crude Oil Prices

Rebound Hits A Wall

The recent swoon in oil prices comes as the market enters the fall “shoulder season,” a seasonally weak period between the summer driving season and the Northern Hemisphere winter. That seasonal weakness has been exacerbated this year by rebounding supply and demand that seems to have hit a wall.

According to the International Energy Agency (IEA), global oil production grew by 2.5 million barrels per day in August as OPEC and U.S. oil producers boosted their output in August.

Initial supply cuts by producers—particularly a giant 9.7 million barrel per day cut by OPEC and its allies—had been successful in helping oil prices recover from their worst levels. But that success led the group to ease those cuts last month; the latest estimates suggest output curbs are currently around 7.7 million barrels per day in total, a reduction of 2 million barrels per day.

At the same time, the recovery in worldwide oil demand may have reached a near-term top, “reflecting the stalling of mobility as the number of COVID-19 cases remains high, and weakness in the aviation sector,” says the IEA.

Not Dire Straits

To be sure, the oil market is nowhere close to the dire straits it was in back during April, when WTI prices fell to minus $37.63.

WTI Crude Oil Prices

Supply is down since then (thanks to voluntary and involuntary cuts) and demand is up (thanks to the easing of lockdown measures around the world).

But that’s still not a recipe for much higher prices, as this week’s slide shows. The 7.7 million barrels per day of OPEC+ production curbs is supply waiting to come on to the market; and demand may struggle in an environment of tepid economic growth and a world that is gradually transitioning away from fossil fuels.

Still, there is a bullish case to be made that all of this year’s mayhem, including the sharp reduction in oil-related capital expenditures, may result in significantly lower supply down the line. But that’s something that could take years to play out.

Challenges Ahead

In the meantime, investors in oil ETFs may have to contend with more volatility. Over the past week, the United States Oil Fund LP (USO) and the United States Brent Oil Fund LP (BNO) are down more than 8% apiece. The Energy Select Sector SDPR Fund (XLE), which tracks energy stocks, is down 4%.

Year to date, the funds are down 73%, 50% and 41.5%, respectively—lousy returns in a year in which the S&P 500, gold and bonds are all up.

USO’s and BNO’s losses have outpaced the 38% decline in underlying oil prices. Roll costs from contango have eaten into the ETFs’ performance.

YTD Returns For WTI, USO, BNO, XLE

Meanwhile, energy stocks are the worst performers within the S&P 500. XLE’s 41.5% loss dwarfs the 17.9% loss for the Financial Select Sector SPDR Fund (XLF), an ETF that tracks financials, the second-worst-performing sector this year. In fact, the energy sector’s weighting in the S&P 500 is now a mere 2.3%, the lowest among all 11 sectors and a dramatic turnaround from the 11% weighting the sector had a decade ago.

Investors’ enthusiasm for energy stocks is at an all-time low. It will take a big improvement in fundamentals to turn that around.

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

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