Oil Slick – $USO

by Dan March 9, 2016 1:27 pm • Commentary• Trade Ideas

Prior to Crude Oil’s 45% rally off of last month’s 13 year lows, the commodity declined 75% from its 2014 high, remains 65% off of those levels, and is down about 75% from its 2008 highs. Over a ten year period the bounce has looked like a blip, but it sure beats a sharp stick in the eye if you’ve been long.

Crude 10 year chart from Bloomberg
Crude 10 year chart from Bloomberg

There has been lots of excitement among investors and in the financial press about the potential that oil prices might have bottomed, but I would argue its a lot more complicated than just the recent price appreciation. Chinese demand, U.S. production and a whole host of geopolitical issues in the Middle East and South America are driving factors, and will likely remain headwinds to $100 oil for years if not decades.  Oh and let’s not forget debt in the sector and among sovereigns, global monetary and fiscal policy and the price of the dollar, etc, etc.  Before we call a bottom, let’s first get a sense for central bank policies to be rolled out by the ECB, BOJ and the FOMC over the next week, and their effect on currencies for the balance of the year.  As my friend BK likes to say, “get the Dollar right, and you’ll likely have a good bead on the rest. This is very much the case for commodities like Oil“.  Frankly I have no idea what’s gonna happen next with oil, but regular readers know I don’t chase crap like this when the reasons given are so weak.

For those who can’t trade oil futures, there are few ways to bet on the price of oil in the equity market. There are etfs like USO, but there is a massive drag on the performance of these due to the roll of futures contracts on the downside. For instance USO had a peak to trough decline of 80% from its 2014 high, not too dissimilar to Crude, but is only up about 30% from its Feb lows, while Crude is up about 45%.

The reason for that is the roll in the futures that USO must do each day. The USO owns a mix of front month and the following month futures. It must sell a portion of the futures it owns that expire soon, and buy the next month’s expiration in order to always have the same position. These futures obviously have different prices and when the sale is lower than the buy each day the USO loses a little bit of money every day. Right now April futures are about 1.80 lower than May futures. So over the span of a month that means that USO is currently giving up about 5% in value just doing its daily futures roll (1.80/38). (April Futures are $38 and May futures are 39.80).

So that’s a significant headwind as long as that roll cost remains. And it will as long as people think the price of oil in the near future will be more than it is today. But from a trading perspective it’s great if you want to take the other side of the USO etf’s drag. So we’re going to go over a couple ways options can help those that own USO as well as those that want to fade this move.  

First, for those that own USO for a continued turnaround in oil, be careful. As we explain above there’s significant drag on the instrument. So those that are long and want to stay long for the time being, selling upside calls to help with some of the premium decay probably makes sense. (e.g. April 11 calls)

And for those that want to fade this move, selling upside calls to buy downside puts makes a ton of sense. (e.g. buying the April 9 puts, selling April 11 calls).

We’re not ready to get involved in USO either way right now but we love keeping an eye on it and will look to maybe get involved from the short side if an opportunity presents itself.  Just as the commodity obviously overshot on the downside, it could also do so on the upside.

Stay tuned for our next post which we think could be a safer, more liquid way to fade the recent move in oil.