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Main thesis & background
The purpose of this article is to review the ProShares Ultra Bloomberg Crude Oil ETF (NYSEARCA:UCO) as an investment opportunity at the current market price. UCO is a double length instrument, designed to return twice the daily performance of the Bloomberg Commodity Balanced WTI Crude Oil Index. This is a futures market product so it may not directly follow the current price of crude oil, but personally I think it’s an equally good way to gain exposure to the oil market.
UCO continues to grab my attention because it was a big winner in 2022. This is significant as most stocks/funds/sectors/themes have had a rough ride this year. In contrast, UCO’s leveraged exposure to a rising commodity has allowed it to generate generous returns YTD:
YTD Price – UCO (search alpha)
Of course, this chart also shows that UCO is not prone to heavy sell-offs either. It has fallen significantly since its high in late May, suggesting that investors need to approach their positions cautiously and within their risk tolerance.
That being said, I believe positions in UCO are very warranted here. I like crude oil as a hedge against equities, commodities in general can do well if inflation stays high, and OPEC+ production cuts and a dwindling US SPR balance are all factors that could push prices higher. While global demand could be challenged going forward, I expect rising demand, particularly in China, to offset this. Therefore, I see a justification for a buy recommendation for UCO and will explain in detail why below.
OPEC+ shows that it will support the market
As I said above, I see several reasons why Crude Oil could rise in the coming months. A key reason for this is that OPEC+ recently took action to support prices in the near term. This is significant as a production cut will help limit supply (and therefore, other things being equal, push up prices). But it also shows theirs Willingness to respond to market conditions and take action regardless of the political consequences of their main buyers (ie the US). To me, this last part is much more important because it will limit the decline in crude oil going forward. If the market believes prices are getting too low and OPEC+ will cut production again, this threat acts as an inherent control preventing much lower prices.
Specifically, OPEC+ agreed to a 2 million bpd production cut in early October. This act of cutting production is a sharp policy reversal for OPEC+. The last time the company cut oil production was in May 2020 when demand collapsed in the early days of the Covid pandemic. To see that they’re taking action now when demand was generally up in 2022 is a bold move.
Ultimately, my conclusion is that investors can use this as justification for buying crude oil. OPEC+ controls a large percentage of global supply and their decision to cut production is having a positive impact on current prices and acting as a buffer against lower prices in the longer term. The world is clearly misaligned with crude oil demand and supply expectations and I would use this uncertainty as a buy signal.
Using SPRs to lower prices is a fool’s game
My next topic concerns the current US administration’s use of Strategic Petroleum Reserves (SPRs) as a tool to combat higher prices. In general I see this as very stupid and the net result wasn’t all that effective. The idea is that by releasing SPRs, the US can bring prices down and thus bring my offering to market. This is intended to exonerate consumers and has recently been seen as a political tool to boost President Biden’s popularity.
I see two problems with this. First, the release of SPRs doesn’t change the general demand-supply imbalance around the world. SPRs are made from existing crude oil. They are already included in the worldwide supply – even if they are not technically “for sale” on the market before the “release”. But the market is aware of their presence and therefore they are already partly reflected in the current prices. Therefore the impact is minimal. Second, the US doesn’t have enough SPRs to really change the demand-supply balance on a global scale with modest releases on a scheduled basis. This announcement can easily be countered by others who are reducing production to keep the current supply-demand scale in current equilibrium – and that is exactly what is happening if we consider the recent OPEC+ decision.
Third, and perhaps most importantly, these SPRs must be replaced if the US is to manage an effective emergency crude oil supply (the original intention of having them in the first place!). So while the “supply” in the market is meant to push prices down, in reality the market is now pricing in the replenishment of that supply. Again, the net impact is very small and not a productive tool.
To look at the impact I’m talking about, let’s look at the SPR balance sheet. Following the Biden administration’s continued release of SPRs, reserve levels have now fallen to their lowest since 1984!
SPR balance (US Energy Information Administration)
My conclusion here is that any short-term benefit for crude oil will be mitigated by the long-term implication of the US becoming a net buyer again to replace these dwindling reserves. As such, I see the release of SPRs as an ineffective way to drive down crude oil prices, and I simply ignore this as a headwind when suggesting that funds like UCO will rise.
The strong dollar has kept prices in check. If the Fed eases, the story changes
I will now reflect on a key risk that I do See for my purchase work in the future. As mentioned, I’m a real oil bull and stand by my UCO buy call. But that’s not to say this game isn’t risk-free. While I don’t see releasing SPRs as a risk, there are other real risks out there. One of them, in particular, is a strong US dollar. The rise in the dollar is generally negatively correlated with commodities such as oil and gold, which are priced in dollars. So it’s not too surprising that oil’s recent weakness came at a time when the USD has been steadily rising:
dollar index (Blumberg)
So – why is this important?
It matters because the USD is strengthening in relative terms against a basket of foreign currencies. Many of these are emerging market currencies, but also yen, sterling, euro, etc. The bottom line is that for oil-consuming nations whose currencies are not pegged to the greenback, oil prices have risen much more sharply in local currency terms. This means it costs more of their local currency to buy the same amount of crude oil. In general, this puts pressure on local markets and demand suffers. If this continues, it will limit upside to Crude Oil as overall global demand could suffer.
That makes me think about how likely that is. Importantly, we need to recognize that USD strength is (partially) fueled by the US Federal Reserve’s aggressive rate hikes. When interest rates rise, the currency often follows. Since most central banks have not been quite as aggressive as our Fed, the USD has risen. The risk here is that the Fed will continue down this path, and it is very likely. Futures markets are indeed forecasting another Fed hike in November, and more could follow:
Fed watch tool (CME group)
The general thought here is that further rate hikes will result in continued USD strength. If so, we could see oil prices coming under pressure despite some of the positive catalysts I mentioned earlier. This is a real risk to manage, so readers should pay close attention to inflation reports and comments from Fed officials going forward.
The counterargument here is that the Fed’s outlook could change once US inflation has already (or is about to) ‘peak’. With the market pricing in rate hikes through early 2023, a change in tone and action from the Fed will see yields fall along with the USD. This will likely drive both stock and crude oil prices higher.
The fact of the matter is that right now no one knows what inflation or the Fed will do 3-6 months from now. All we can do is create our best estimate and invest accordingly. But market sentiment appears to be changing. As reported by Fortune, a growing number of fund managers believe the worst of inflation is actually behind us:
poll results (Bank of America)
Again, feelings don’t always translate into reality. But it shows that the Fed hawks’ surge against the USD, which has kept oil prices in check, could be nearing the end of its cycle. If this is the case, UCO will recover.
China The wild card
My last topic concerns the economic realities in China. As readers are likely to know, the Chinese government has taken a tough approach to Covid-19 this year. This is in stark contrast to how most nations around the world are coping with the ongoing pandemic. Other top oil consumers like the US, Eurozone, India and others have mostly reopened their economies and are seeing demand for energy rising.
China, on the other hand, has imposed travel bans and quarantine rules that have dampened economic activity and significantly reduced oil demand:
Chinese cities in lockdown (`)
China’s economic activity (Reuters)
The bottom line for me is that China is the wildcard for how the oil market will shape in early 2023. If the country falls into lockdown fatigue and the rest of the developed world reopens, then demand for crude oil is likely to see an immediate boon and that will push prices up quite significantly until supply catches up. On the other hand, if China remains in the relatively strict lockdown mode, all bets are off. We need to focus more closely on what is happening to US production after the November elections and further OPEC+ moves. This speaks to the general uncertainty in the oil market at the moment and why investors in UCO should brace themselves for continued volatility.
bottom line
UCO has had a great year despite struggling in recent months. I see the weakness since late June as a buying opportunity to take advantage of rising oil prices in late 2022 and early 2023. I see OPEC+’s willingness to cut production, the lack of a coherent US energy policy and a potential demand rebound in China, and a less aggressive Fed next year as catalysts for higher prices going forward. If this is the case, UCO will recover from these levels. I plan to build on my current involvement with the fund and suggest that readers give this idea some thought at this point.
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