10 per barrel rally in crude oil has now brought the market more than 35% off its low made just one month ago. The recent rally could find increasing its gains difficult as it heads into seasonal and technical resistance as you’ll see on the enclosed chart.
According to the International Energy Agency (“IEA”) the oil supply glut is set to continue until well into 2016.
Inevitably there will be some people who will say that the IEA is deliberately talking down the market so as to encourage a low oil price, which is presumed to be beneficial for Western economies.
What the IEA is predicting however follows the classic pattern of an over-supply glut.
The initial response of producers to a supply glut is to increase rather than cut back production as a way of keeping market share and maintaining cash flow through higher sales. Heavily indebted marginal producers like the shale producers in the US tend to do this to an even greater degree than more established producers, since they have to maintain cash flow to pay their debts.
The result is that as production grows the supply glut increases driving prices down even more.
This is the process the IEA is describing and given the state of the market and the debt financing needs of US shale producers - the weakest link in the industry - it makes complete sense.
Oil is by no means unique in following this pattern. One of the reasons for the “dust bowls” in the US in the 1930s was the removal of top soils by US farmers driven to overproduce in the 1920s by low prices caused by the conditions of over supply created by the preceding period of high prices before and during the First World War.
Falling prices during the supply glut caused by rising production however eventually undermine the position of marginal producers, especially if as US farmers were in the 1920s and as some US shale producers are today, they are heavily indebted.
In the 1930s in the US farm industry there was actually a foreclosure crisis. It is not completely impossible that something similar may eventually happen amongst weaker producers in the US shale industry.
Once the process has finally run its course prices will recover - probably by more than some assume.
The last few months have shown that Russia is capable of weathering the oil price fall. Indeed a period of lower oil prices is arguably beneficial to an economy with low debt that wants to expand its agricultural and manufacturing base. Used properly a period of low oil prices should encourage higher investment in agriculture and manufacturing as opposed to energy, which has had a disproportionate share of investment up to now.
For this period of lower oil prices to be used properly, so that long-term investment in manufacturing and industry become truly profitable, inflation and interest rates need to fall below what have been their historic levels in Russia, which is why the government is so single-mindedly focused on lowering inflation.
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The rebalancing of the oil market that started last year has yet to run its course and a bottom in prices “may still be ahead”, according to the world’s leading energy forecaster.
In a bearish assessment of market conditions the International Energy Agency said the adjustment process would “extend well into 2016” as production — led by Opec nations — continued to swell and demand growth softened.
The Paris-based agency, which advises the world’s biggest economies on energy policy, said the oil market was “massively oversupplied”.
Global oil supply surged by 550,000 barrels a day in June to 96.6m b/d, up 3.1m b/d from the same month a year ago, the IEA said in a widely followed monthly report
“The market’s ability to absorb that oversupply is unlikely to last. Onshore storage space is limited. So is the tanker fleet. New refineries do not get built every day,” the IEA said. “Something has to give.”
That something could be US shale oil, the agency said. Relentless supply growth from North America has been one of the factors contributing to the glut in crude oil.
While some weakness in US shale oil output was beginning to show “it may also take another price drop for the full supply response to unfold”, the IEA warned.
Oil prices on both sides of the Atlantic fell sharply this week, with Brent crude — the international benchmark — entering bear market territory. Brent hit $55 a barrel on Monday, rattled by the financial turmoil in Greece and the stock market rout in China. On Friday Brent had risen back to $59 a barrel — a level that is still almost 50 per cent lower than last year’s $115 a barrel June peak.
Cost savings, efficiency gains and hedging have helped shale producers “defy expectations”until now, but supply growth ground to a halt in May and is forecast to stay at these levels through mid-2016, the IEA noted. After growing at 1.7m b/d in 2014, US shale onshore production is forecast to slow to 900,000 b/d this year and 300,000 b/d in 2016.
As a whole, the IEA expects non-Opec supply growth will slow to 1m b/d in 2015 and stay flat in 2016 as lower oil prices and spending cuts take hold.
Although the IEA increased its global demand growth forecast for 2016 to 1.2m b/d — taking total demand to 95.2m b/d — it is still less than 1.4m b/d it predicts for this year.
“World oil demand growth appears to have peaked in the first quarter of 2015 at 1.8m barrels a day and will continue to ease throughout the rest of this year and into next,” said the IEA.
A possible Greek exit from the eurozone could suppress demand across the continent if economic activity was to weaken, the IEA said.
The agency said that would not translate into a “tighter market” for oil in 2016 as long as members of Opec, the oil producing cartel, continued to pump at near record levels.
“The group is not slowing down. On the contrary, its core Middle East producers are pumping at record rates and the outlook for Iraqi capacity growth — accounting for most projected Opec expansions — keeps improving,” it said.
Opec crude supply reached a three-year high in June to 31.7m b/d, up 340,000 b/d from the prior month, led by Iraq, Saudi Arabia and the UAE.
The IEA estimates that the demand for the cartel’s crude will stand at 30.3m b/d next year, up 1m b/d from 2015. But this is still a “whopping” 1.4m b/d less than its current production.
The year 2015 may have been dull and quite for the broader market, breaking a prolonged bull run, but a few segments kept the market noisy. Crude oil takes the first spot in this league followed by other forms of energy like natural gas while overall commodities, metals and some country investments round out the top five positions.
Definitely, these noises emanated from panic; not from cheers. The persistent slump in oil prices, a broad-based acute slump in commodities, a super slowdown in metals instigated mainly by the China-led worries (China is the main consumer of global metals) and upheaval in some countries like Brazil kept the global stock returns at check in 2015.
However, as they say –– someone's pain is someone’s gain. The rule applies in the ETF world as well. There are plenty of investment opportunities in the ETF world to make quick and hefty bucks from any investment’s downturn via an inverse leveraged approach.
However, these funds run high risk of losses compared with traditional funds due to the short-term nature of investments of the former. Further, their performances could vary significantly from the actual performance of their underlying index over a longer period when compared to a shorter period. These investments are not meant to be held for long and vary big-time even with slight changes in investment dynamics.
Whatever the case, below we highlight eight inverse leveraged ETFs that have offered at least 70% returns so far this year (as of December 29, 2015) against the S&P-based broader market ETFSPY’s 0.9% gains. Notably, Zacks does not rank inverse and leveraged ETFs in view of their short-term performance objectives.
DB Crude Oil Double Short ETN (DTO) – Up 100.88%
Oil is presently the worst investment possible due to an acute supply gut and low demand issues. Talks about no production cut from OPEC nations added further woes to this liquid commodity investment. As a result, ETFs shorting oil-related index made huge gains (read: 5 ETF Losers of 2015 Hoping for a Rebound in 2016).
This ETN provides twice the inverse exposure to the Deutsche Bank Liquid Commodity Index-Light Crude, which tracks the performance of a basket of WTI oil futures contracts. It has amassed $64.4 million in its asset base and trades in a moderate daily volume of roughly 90,000 shares. The product charges 75 bps in fees per year from investors (read: Still Believe in Goldman's $20 Oil? Go Short With These ETFs).
ProShares UltraShort Bloomberg Crude Oil (SCO) offering twice the negative impact of the daily performance of the Bloomberg WTI Crude Oil Subindex has added 79.33% so far this year (as of December 29, 2015). VelocityShares 3x Inverse Crude Oil ETN (DWTI) is yet another inverse leveraged crude fund that has gained 76.42% during this timeframe.
So, for investors seeking to make an inverse bet on oil, we have highlighted below four ETFs, any of which can be used to make a short play on oil.
However, investors should keep in mind that a short play in the futures market requires a strong appetite for risks.
ProShares UltraShort DJ-UBS Crude Oil ETF (SCO)
SCO is the most popular option in the short oil ETF space having an asset base of $169.1 million. The fund tracks the Dow Jones-UBS Crude Oil Sub-Index to provide twice the inverse performance, on a daily basis of WTI crude oil.
Volumes are also great as roughly 1.3 million shares change hand daily. However, expenses are a bit steep at roughly 95 basis points annually.
PowerShares DB Crude Oil Double Short ETN (DTO)
Investors seeking to use the ETN approach to inverse crude investing can consider DTO for exposure. The fund follows a benchmark of crude oil futures contracts to provide -2x exposure.
While the fund manages a small AUM of $66.9 million, volumes are pretty good at about 110,000 shares a day. Also, the fund is relatively cheaper with 75 basis points as annual fees (see all Inverse Commodity ETFs here).
PowerShares DB Crude Oil Short ETN (SZO)
SZO is the least risky bet in the space providing -1x short exposure to WTI crude. The ETN tracks the Deutsche Bank Liquid Commodity Index-Oil for this purpose, while it also adds in the yield from short-term T-bills.
However, the product is quite unpopular with an asset base of just $7.8 million and trades with low volumes of under 3,000 shares, which might result in additional costs in the form of wide bid-ask spreads. Expenses come in at 75 basis points annually.
VelocityShares 3x Inverse Crude ETN (DWTI)
DWTI is one of the riskier ways to play the short oil market, utilizing -3x exposure with daily rebalancing. The fund tracks the S&P GSCI Crude Oil Index to provide exposure to crude oil.
However, the product is quite unpopular with a low asset base of trading volume. Moreover, it is quite pricey charging 1.35% as annual fees. $
There are a couple of large factors at work in the current crude oil environment. First of all, crude oil pricing has clearly shifted its traditional trading boundaries. Crude oil has made every attempt to install systemically higher prices since 2000 when US consumption ramped up on imported oil and drove prices above $140 per barrel thus, auguring in the fracking era. The rush to exploit North American reserves at very profitable margins in the name of, “energy independence” has now created a supply glut and driven prices back to the original $25-$40 per barrel of the early 2000’s. The supply glut is expected to take at least a year to work through at current economic activity levels. However, it is quite possible that forward global GDP will be revised downward as major economies enact negative interest rate policies. Thus, prolonging the supply overhang. Classic economics leads us to believe that prices will equalize, “at the margin” where the most efficient producers can capture market share at lower total prices. We think the 2016 equalization level will be less than $40 per barrel.
This brings us to the current situation as the recent rally begins to test resistance at $40 per barrel while heading into a classic seasonal peak. We think crude oil’s new upper boundary will be defined by the resistance at $42.50 which had acted as support this past fall. This will also time out well with last of the refiners’ buying as they prepare for Memorial Day’s kickoff of the summer blends and the seasonal peak occurring near the end of April. You can see on the enclosed chart this year’s pattern is taking on a pretty similar appearance to last year’s.
Crude oil is currently overbought on a short-term basis and overvalued based on the commercial traders’ collective actions. When we combine this with overhead technical resistance and the expectation of a seasonal peak, it puts us on the lookout for sellable rallies or momentum reversals lower. Many of these factors have been included in our fully
mechanical Commitment of Traders programs. We’ll update this scenario accordingly and announce the sell signal once it’s officially triggered.
