USO: A Bottom Could Be Forming (NYSEARCA:USO)
Oil prices seem to have plateaued, following the drop in H2’22 and is ranging in the US$75-80 range for WTI. However, the market dynamics is changing in what I believe is a pretty supportive environment for oil prices. While the releases from the US SPR were stopped, pulling out supply from the market, China is rapidly reopening its economy. At the same time, US rig count dynamics indicate that the industry may be seeking higher prices in order to be incentivized to increase production. I believe all of these factors are pretty bullish for oil and current levels could be the bottom. Those investors who seek oil exposure without the risks typical for an oil producer could use The United States Oil ETF (NYSEARCA:USO).
US SPR recent developments
Following the Russian invasion in Ukraine, the US decided to release unprecedented amounts of 180M barrels from its Strategic Petroleum Reserve (SPR). However, in November the release was completed, although stocks at the SPR continued to fall through the end of the year. In January 2023, their level has stabilized around 371.6M barrels. As the released quantities began hitting the market it was not long before oil prices reacted and retreated from their highs. That being said, as releases from the SPR were finished, the downward move in oil seems to have finished as well.
While the release unprecedented amounts of oil from the SPR may have helped to contain the skyrocketing crude prices, the decision has faced some political backlash. In light of this, the House passed a bill to limit the US administration power to make future releases. Also, the Department of Energy was making moves to potentially begin resupplying the SPR, but the submitted offers were rejected, likely on pricing.
I find the SPR factor very significant for oil price movement in 2022, as between April and November, the releases from the reserve added around 0.8M barrels per day on the supply side. Now these quantities have evaporated from the market balance equation.
US rig count dynamics and implications
The most important factor on the supply side – OPEC+ has already signaled intentions to defend the high price environment by cutting supply without waiting for oil to collapse. This is understandable – OPEC+ countries rely heavily on crude revenues to support their budgets and have reaped the benefits of the high price environment for a year and a half.
As the cartel is unwilling to raise output, the US, which is the largest oil producer, should do the heavy lifting. However, at the beginning of his presidency, Biden has signaled intentions to curb drilling on federal land. Also, the push towards “green” economy continues to this day. Such an environment brings uncertainty to oil firms so they’re more tilted towards returning value to their shareholders instead of investing heavily in expansion. The drop in oil prices in H2’22 have not helped either and US rig count has been falling down recently, recording its biggest weekly drop since June 2020.
Without rapid and meaningful rig count increase the US oil output will have hard time increasing. Even maintaining the current levels may be in question as shale formations exhibit high decline rates of up to 50%, making it detrimental to constantly invest to keep production at a certain level.
Russia – supply uncertainties
As part of the sanction packages that the EU imposed on Russia, oil and oil products have been banned as well. Also, G7 has introduced price cap on Russian oil at US$60/barrel. As a response, Russia halted sales to countries that are part of the sanctions and threatened to cut supply by up to 7% (approx. 0.7M barrels).
Obviously this situation brings further uncertainty to the market. On one hand, Russia needs the oil revenues, so some may argue that Russian oil output may be increased. However, since oil market balance seems fragile, by cutting production, Russians may send the price considerably higher and end up making more money. Another question is whether the country will be able to maintain production given that sanctions include various equipment and technologies that are used in the oil extraction process.
For now, it seems that the embargo is being sidestepped through third-countries acting as intermediaries. Still, while being the second largest producer of oil, Russia remains the uncertainty factor on the oil market balance that could potentially send the price of oil soaring.
The China factor
For almost three years, from 2020 to 2022, China has been in some form of lockdown as a response to the pandemic in the pursuit of Covid-zero policy. However, at the end of 2022, there’s been a rapid shift in policy and the country is removing the restrictions. Over a billion people that have been stuck at their homes for most of this time will now be allowed to travel and live as before. I think that this alone will be a major source of oil demand as pent-up demand for travel hits the market. This is exactly what happened in Europe and North America as restrictions there were relaxed, which was one of the reasons for the booming oil price in 2021 and 2022. In light of this, Chinese oil consumption is expected to hit a record in 2023.
All of the above mentioned factors lead me to believe that the current oil price level may be a bottom and a move to the upside should be coming. One way to play this thesis would be through equities of oil companies. However, while offering leverage on the price of the commodity, this approach involves assuming additional risks, specific to oil equities. For example, many countries are reaching deeper into oil companies’ pockets by introducing windfall taxes.
Another was to get exposure to the oil price could be through The United States Oil ETF. It is designed to track the performance of oil prices and uses features contracts of various maturities to do so. However, it has an expense ratio of 0.81%, which is quite substantial.
Due to the use of long-dated futures, USO suffers from negative roll yield when the oil price is in contango. This leads to inferior performance over long-periods of time, so USO is more appropriate for short term-horizons. However, as I think that we’re likely to see upside move in oil prices rather soon, USO may be an appropriate instrument for the occasion.
Recent development on the oil market seems quite bullish. On one hand the releases from the US SPR are over, while US oil rig count is falling, indicating that firms are seeking higher prices to incentivize production growth. There are also many uncertainties about the Russian oil supply on the back of sanctions and the oil price cap. At the same time, China is reopening, which could release massive pent-up demand for travel of its people. In turn, this should increase oil demand considerably, pressuring crude prices to the upside.