What Happens When an Oil ETF Can’t Buy Oil?

I don’t think I’ve ever received as many phone calls, emails, or text messages in one day as I did when oil prices went negative last month. I am still catching up with all those folks, which is frankly a welcome task during our continued isolation.

By far, the most common question I received was “so I should buy an oil ETF now and just hold it for a few years, right?”

On the surface, that might seem like a completely reasonable take. And if all you’re following is oil prices, then technically the percent return from -$37.65/barrel to yesterday’s close of $33.92/barrel is infinite.

But my answer to “should I buy an oil ETF?” was an emphatic, all-caps NO.

While that might be counterintuitive, the inherent risk in making that investment at that time wasn’t that oil prices wouldn’t go up… they most certainly would.

It’s that the oil ETF they chose might cease to exist.

In fact, the biggest oil ETF – the United States Oil Fund (NYSEArca:USO) – controlled nearly one-third of front-month oil contracts at the time of the commodity’s collapse.

So they weren’t just caught up in the negative price problem, they were also a cause of it… so much so that hedge funds tried to destroy it.

And just yesterday afternoon, news began to circulate that USO’s broker – RBC Capital Markets – would block them from buying crude futures due to internal risk management requirements and regulatory intervention.

Just a guess – but I figure it will be hard to track the oil market if you can’t buy or sell oil.

The flip side of this, of course, is that 30% of near-term demand is a lot for the market to give up. And taking USO out of the market at a time when US crude storage levels are hovering near all-time highs (chart below) means that the price action we see in crude oil for the next few weeks might resemble reality.

Source: EIA, Bloomberg

And reality looks bearish.

Because at the end of the day, we don’t consume crude oil, we consume its refined products – primarily gasoline, diesel, and jet fuel.

Now, I wrote on Wednesday about how the world still isn’t driving much, and that trend is likely to be around for a while.

As a result, we’re not consuming as much gasoline… which is showing up in all-time high storage levels for this time of year.

Source: EIA, Bloomberg

But we’re also not flying anywhere, with airlines and TSA reporting a 96% drop in air travel last month.

And since it’s not going into planes, all that jet fuel – which accounts for 8 million barrels per day of crude oil demand – has to go somewhere.

Refiners basically have two options there.

They could put a large percentage of it into gasoline if they wanted. But as I just mentioned, we’re at all-time high storage levels for this time of year, and uncomfortably close to storage capacity.

The only other option is just to throw all that jet fuel into the diesel cut. That is exactly what they have done, pushing storage levels to – you guessed it – all time highs for this time of year.

Source: EIA, Bloomberg

And we are now seeing that play out in pricing – something you’ve probably noticed if you drive one of those sweet diesel F-150’s I mentioned in last week’s article – with diesel prices falling below gasoline.

Source: EIA, Bloomberg

And that has again pushed refinery margins back toward multi-year lows.

Source: EIA, Bloomberg

So, with demand still down for gasoline, diesel and jet fuel, and storage levels of crude oil still incredibly elevated, it stands to reason that oil prices have gotten out a little too far over their skis.

In fact, at this price level, we are even starting to see some well restarts in the Permian Basin, which will likely keep still-high US oil production levels elevated for longer.

Source: EIA, Bloomberg

And now with USO – a key source of oil price action – essentially cut off from participating in markets, it appears prices are generally headed lower over the next month or so.

So first off, let’s grab another ¼ stake in ProShares UltraShort Bloomberg Crude Oil (NYSEArca:SCO). For now, it still has access to crude futures and is spread across the near-term curve. If that changes, we will adjust.

But also, with gasoline and diesel storage levels that high, it brings refined product tankers – and our old friend Scorpio Tankers (NYSE:STNG) – back into focus.

Shipping rates for gasoline and diesel (chart below) have come way down over the last few weeks as Japan’s activity has been minimal during their most recent coronavirus lockdown.

Source: EIA, Bloomberg

And that gives us a chance to pick up a brand new ¼ stake in STNG at below $17 –a value I just can’t pass up here.

That’s it for this week, but I’m currently digging into data on foreign currency and gold reserves around the world, with the intention of pairing them with sovereign debt levels and access to IMF funding.

Why, you might ask?

Because China is moving to directly impose a new security law on Hong Kong that would effectively end the semi-autonomous freedoms that HK currently holds. When that happened last year, we saw widespread protests as a result.

What happens this time around could be even more serious, perhaps sending shockwaves through global currency markets.

Ultimately, that will have an impact on our position in Direxion Daily MSCI Emerging Markets Bear 3X Shares (NYSEArca: EDZ)… but we’ll talk about that more after the holiday.

Speaking of which, here’s wishing you and yours a happy Memorial Day weekend… stay safe and be well.

All the best,

Matt Warder

Venture Society

This article is supplied courtesy of WealthPress.com

 

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