April 20 might go down in the history books as the Black Monday for oil investors. The WTI crude oil price fell to a negative $37 per barrel, which implies sellers were willing to pay buyers to take their stock of oil. This marks the first time oil fell below zero, which goes on to reveal how catastrophic this event is.
I have published a few articles on GuruFocus discussing why shares of energy companies are an attractive investment amid the chaos in capital markets. Even after the historic drop in oil prices, there’s reason to believe that some energy giants are poised to deliver stellar returns to investors. However, The United States Oil ETF, LP (USO, Financial) is not the best way to gain exposure to the energy market, for reasons that will be discussed in this analysis.
How did oil fall into negative territory?
An understanding of the pricing mechanism behind commodities is necessary to gain an understanding of the recent collapse in prices. One important thing to know is that the WTI crude oil price that investors see on major financial media and other research platforms is not the spot price. The standard practice is to use the front-month futures contracts price. In this case, May 1 dated contracts expired on April 20, which led to the massive sell-off because of three primary reasons:
- According to data from Bloomberg, the United States Oil fund owned approximately 25% of all outstanding May contracts, and the fund dumped these in the open market to buy June contracts. This created a massive sell-side pressure.
- Speculative traders who never had the intention of owning physical oil barrels followed suit and disposed of their positions.
- Generally, commercial buyers come to the rescue and purchase these contracts. These are the companies that store oil for business purposes. However, this time around, the storage capacities were already approaching a peak due to the reduced demand for oil in the last few weeks while supply remained at elevated levels. There was no demand for the expiring contracts even though the price fell to record lows.
The combination of these three developments led oil into negative territory last Monday. The Brent crude, on the other hand, did not follow suit, as storage capacities did not become a question for the European benchmark. Even more important to note is the fact that June contracts are still trading above $14 per barrel.
Undermining the fundamental problem of declining demand for oil as a result of the global lockdown is not wise, but this was not the driver of oil into negative prices. The futures pricing mechanism and the shortage in storage facilities are to be blamed for this historic drop.
More short-term troubles for energy investors
The storage problems in the United States might continue in the next month as well. This is bad news for the industry. The supply cuts proposed by the OPEC+ alliance are welcome news, but it would take a few weeks for stored oil to reach the market. Therefore, Cushing oil storage facilities will most likely operate at unusually high utilization levels.
Source: S&P 500 Global Intelligence
If the inventories continue to build up through mid-May, both speculative investors and the United States Oil fund will once again dump their June contracts, leading to another massive decline in WTI crude oil prices.
From a more fundamental perspective, the demand for the commodity is not expected to stage a comeback in the next month as well, primarily due to the global lockdown that has brought manufacturing activities to a standstill.
The downside to investing in the United States Oil fund
The historic drop in oil prices triggered a sell-off of the share price of the fund as well. The market value of the fund has declined by a staggering 80% since the beginning of the year.
Source: Bloomberg
Contrary to the belief of many retail investors, the fund does not directly invest in oil, and neither does it take physical delivery. Rather, the fund buys front-month contracts and then rolls over on to the next month's futures before the expiry of these financial instruments. In every sense, the United States Oil fund should be treated as a derivative, not a direct investment in the commodity. Therefore, an investor would be exposed to a few additional risks when using this fund to gain exposure to the energy market, as opposed to betting on the equity securities of publicly listed energy companies such as Exxon Mobil Corporation (XOM, Financial).
There’s another important development that has made investing in this fund a very risky way to bet on the expected recovery of energy prices. The oil market is in contango, meaning that the futures contracts are trading at a premium to the spot price, which is an ominous sign for the fund. According to data from the U.S. Energy Information Administration, the futures price is $10.01 per barrel in comparison to the spot price of $8.91 on April 22. As long as this phenomenon continues, the fund will be making losses during the process of rolling over the contracts, as this is equivalent to selling low and buying high.
Institutional and well-informed investors who possess a thorough understanding of these dynamics are staying away from this fund, whereas the opposite is true for retail investors. Data compiled by Robintrack, a website that collects data from Robinhood, one of the most popular investing platforms among investors, is testimony to the sudden increase in interest for the oil fund among small-scale investors.
Source: Robintrack
The fund, on the other hand, is trading at a 36% premium to its net asset value, according to USFC Investments. This makes things worse and serves as a warning sign for another collapse of the market value.
Takeaway: betting on top-tier energy companies seems to be the better strategy
Unlike an investment in the United States Oil fund, betting on the equity securities of an energy company provides direct exposure to crude oil. These companies produce and/or take physical delivery of the commodity, and the market value of an investment in any one of the leading players will not fall beyond zero unless the investor uses leverage. The maximum loss would be the initial investment, but for this to materialize, the company would have to go bankrupt. This is far from reality for big names, as oil prices will not remain under pressure for a prolonged time. The supply cuts proposed by the oil cartel and the expected surge in demand for oil resulting from the stellar economic growth projected by the World Bank will serve as catalysts for energy commodities to move higher.
The drop in the share price of energy companies backed by Gurus, such as Occidental Petroleum Corporation (OXY, Financial), Exxon Mobil Corporation (XOM, Financial) and Suncor Energy Inc. (SU, Financial), might provide attractive opportunities for investors to bank on. However, the United States Oil fund is not the ideal vehicle to bet on the recovery of oil, as the fund is merely a financial instrument that attempts to track the movement of oil prices.
Disclosure: I own shares of Exxon Mobil and Suncor Energy.
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