- Trump’s Tweets won’t have a lasting impact, market forces of underlying supply and demand will take hold again.
- A Cutback of 10 million barrels isn’t enough within the context of the next four months.
- I expect oil to trade above $50 within 12-14 months
- USO & UCO can be used to gain exposure, albeit only if you know what you’re doing and selling volatility in the process
Things have changed rapidly. Just a few weeks ago, the price of the front-month Oil Futures and $USO had one of the best, if not the best weeks in longer than I can remember. I’ve traded energy on and off for over 30 years, so where going back a long time to find something else even remotely close.
Anyone surprised probably shouldn’t be. It was a perfect storm of market panic and worry, with the right dose of positive news to light the fuse on the powder keg of a massive bear-market rally, which is likely exactly what we witnessed last week. I’ve been long Oil via $USO for over a month, and I’ve taken gains and losses along the way as I’ve traded the underlying and option hedges. Once it approached $25, I knew it was well below the cost of so many producers, that at some point, it “had” to go up.
Unfortunately for me, I relearned a lesson this week I’ve paid tuition for many times. Namely, it’s not enough to be right, you also have to have your timing correct. I’m using $USO to gain exposure to oil through a combination of selling puts and buying calls. So far, it’s mostly worked well until the leadership went full-blown amateur-hour panic “sell everything right this minute” and cause a precipitous fall in the futures and of course the USO tracking ETF. This shift fundamentally changed the net asset value (NAV) and caused massive guaranteed losses beyond what one could anticipate with contango. A smarter, more informed person would have seen this coming, albeit I can’t say I did in full. I did expect a short-term drop, and my solution was to sell call options for the next five or six expiration dates out to hedge against it, as well as sell a considerable about of my underlying longs in the Oct and Jan 2021 expiration dates.
The sale of my longs was due to my belief the spike in volatility was pushing the option premium higher and I would be able to restore my long position later at a much better price regardless of what USO did. I was correct, and to give an idea by how much, I was selling Jan $5 calls for about 50-60 cents, and just a few days later, I’m still well below the number sold (give or take about 100 cars) and I was buying back as low as 17 cents, with an average of 23 cents. In other words, the spike in premium gave me an exit I took and it was clear for anyone to see because while USO was down, call options were higher, sometimes, significantly higher. Plus, the calls I sold have now too collapsed in price. While I became net short in the next couple of months, and the vola has dropped enough to enable a significant gain in those options, it’s not nearly enough to cover the losses in my longs.
At the time of placing the hedges, the plan wasn’t to fully account for the downside potential, because to do so would have required giving up the upside or worse, a spike higher (due to Iran or 153 different things) could have destroyed the entire investment thesis with a snap of the finger, however, I think it’s fair to say no one could have predicted USO behaving in the manner it did, albeit I should have read the tea leaves better and not been such a “perma-bull” regarding the return to normal in petro consumption.
So, where does this leave me standing…
Canadian and US producers (along with many other countries) are cutting production. One has to seriously wonder if Canadian oil production will recover at all in the next year. As I write this, concern that OK storage will fill to the top by mid-May. Maybe, albeit there’s a lot of other non-public storage available and investors are placing oil in pipelines (for storage), rail tanks, local tanks, and other places as one would expect a free market to do when faced with this type of situation. Regardless of the situation, the free market does work wonders to protect value and create greater efficiency than central planning. That said, it still may not be enough, and that’s really what the bets being laid down now are indicating. In the meantime, it’s the amount of cuts in production relative to consumption that is the key here with oil investing.
Even if we can cut back 10 million, won’t help right now even if they could (demand destruction is over 15, and maybe 20 million according to Goldman Sachs) and as mentioned, storage is filling up faster than allowing an eight year old to draw a bath unattended. None of it matters though because the Saudis knows if it cuts back production and prices don’t rise, they lose credibility and what’s left of OPEC+ will fade into the wastebasket of irrelevance. Enjoy the cheap gas (while it lasts) because it’s likely to be here for at least a few more months absent a revelation by our fearless and all-knowing government leaders that shutting down 30-40% of the economy will likely result in greater deaths (suicide and greater crime) than “bending the curve” can save. Trump’s tweets and press conference was likely little more than bear market rally. If July and Aug oil holds below $25 in the next couple of weeks (which I’m betting it will), you’ll know just how much of an impact.
Moving forward, we see some of the country is getting “back to work,” and while it makes great headlines grabbing the complete attention and contempt for those who think doing so will “kill us all,” that fact is, while people are overall so nervous, scared, and even at panic levels, there’s not going to be gangbuster, let-r-rip return to business as before right away. Sure, after the herd figures out it’s safe to jump back into the water, which is really hard to gauge based on the media’s desire to prolong this eye-grabbing page view money-making news nirvana. Where the population has nothing better to do than stay glued to the latest news. If you think any of the media outlets are going to let go of this prolonged “media bliss” you’re going to be sadly mistaken. They’re likely to ride this horse until it’s beyond dead and eaten by vultures.
With that in mind, I will remain short during the short-term, and expect weakness in USO post its 1 for 8 reverse split coming up this week. I also believe we can see, as expected, consumption increasing (even if not a lot) as areas open up. I’ve been watching Atlanta traffic on Tom Tom and it’s way too early to draw a conclusion. That said, one would expect at least a bump in traffic, and that’s about all it demonstrated, a slight “perhaps non-statistically significant” move upwards.
It should also be noted that (and I’m going to write about it) it’s my firm belief Convid 19 isn’t nearly as deadly as most people think (while I still see people worried about its 3% or higher mortality rate, I think the best data available suggests a rate below 0.3%, and 0.01% or lower isn’t out of the question). Moreover, those mostly likely to be at risk aren’t in the workforce and out as much as the average person anyway, making both going back to work and staying isolated easier for both groups of people.
Furthermore, I also believe Covid 19 is much more contagious than previously believed and the net result of both of those factors means shutting down the economy is much worse and comes at a significantly higher cost than any benefits received. As time progresses, these factors are almost certainly going to become increasingly obvious to all, even those closed to any thought other than bunkering in their homes in complete and total fear.
Once (assuming I’m correct) it becomes clear over 40% of the US population already has been exposed, and there’s no shortage of hospital ICU beds and stay at home isn’t of any use, gas consumption, along with every other oil use will start to witness a recovery in demand destruction and it wouldn’t be surprising if refiners have to work near capacity to keep up with all those cars now requiring gas because people with 1/2 a tank or less didn’t see the urgency to fill up anytime soon before things opened. Not that I can use my own situation as much of a measurement, albeit my truck sat in the garage for over three weeks without me driving it anywhere. I had a 1/4 tank and filled up at $1.19 a gallon.
I needed to go somewhere, and as I drove, the big thing that struck me was the traffic level (I’m in a very small city) wasn’t noticeably less than what I would have expected if we weren’t in the Covid 19 stay at home situation. I know in bigger cities, ie New York the level of traffic fall is simply breathtaking crazy, however, looking at various live traffic cameras in the country suggests the consumption direction is upward, even if we can’t “feel it” yet.
While we’ll need to see how the market welcomes USO’s reverse split, I’ll remain short the near expiration dates, while remaining long Jan 2021 and beyond. I’m also currently long (and wrong) $UCO, which became officially painful when puts I wrote entered deeply into the money. I’m not waiting for expiration (or buyer exercising which has happened to others during the expiration week with little or no intrinsic value) and I’ll write calls against the shares, with about a three month horizon. Volatility remains high for UCO due to its leveraged profile, albeit it suffers from the same contango value loss as USO. That said, UCO does remain attractive to me as long as I’m also collecting premium for the volatility until it’s clear consumption is returning towards pre-Covid 19 levels. At that point, which is measured in months I think, I’ll remove the hedges and take the full exposure expecting a return to $55+ oil in less than 18 months, and a target of about 12-14 months.
For now, oil isn’t showing any signs I recognize as a bullish short term bet. So, anyone wanting to get long better either be day trading movements, or going in with a long-term view of greater than a year as described above. This means for me, remaining long with near-term hedges to get me through the night….
And it also means a very difficult and challenging time for US oil production for about as far as we can see down the road. Don’t expect a miracle this summer, because even if consumption rises above production (and it might), we have so much oil in storage, it will take a considerable amount of time to work through it.