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Page added on June 15, 2019

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A Battle Between U.S. Production And Iran

Production
Summary

Oil remains above $50 per barrel on WTI and hovers around $60 on Brent.

Another week of inventory builds in the US.

New provocative acts in the Middle East.

Brent-WTI remains firm.

Trading in the current environment could offer the best opportunities – UCO and SCO for those who do not trade futures.

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The global economic and geopolitical landscapes are pulling the price of crude oil in opposite directions. The price of the energy commodity dropped from a high at $66.60 on the nearby NYMEX WTI futures contract and $75.59 on Brent futures in late April to lows that are not far below the current price levels. The escalation of the trade dispute between the US and China is weighing on the global economy, which lowers demand for oil. At the same time, the US walked away from the Iran nuclear nonproliferation agreement in 2018 and put new sanctions on the theocracy in Teheran. Last November, President Trump allowed for exemptions to eight countries that purchase crude oil from Iran. However, in April, the US administration refused to extend those exemptions, which tightened the economic noose around the necks of the leadership of Iran.

On April 22, the Iranians warned that if they are not allowed to sell their oil to customers across the globe, they will prevent other oil-exporting nations in the Middle East from selling their petroleum. The rhetoric between Washington and Teheran has been rising since April, and last week, Iran continued to provoke the US with action rather than words.

The economic and political forces that are pulling crude oil in opposite directions could mean that trading rather than investing is the optimal approach to the crude oil market over the coming weeks. The ProShares Ultra Bloomberg Crude Oil product (UCO) and its bearish counterpart (SCO) are double-leveraged bullish and bearish products that can be useful for those who wish to participate in the ups and downs of the oil market without venturing into the futures arena.

Oil remains above $50 per barrel on WTI and hovers around $60 on Brent

Nearby NYMEX July crude oil futures hit a high at $66.44 per barrel in late April while the continuous futures contract reached $66.60.

Source: CQG

As the daily chart of July NYMEX WTI futures shows, the price dropped to its most recent low at $50.60 per barrel on June 5, a decline of 24% from the April peak. Crude oil was sitting not far off its low at the $52.60 level on Friday, June 14.

Source: CQG

As the daily chart of August Brent futures shows, the price dropped to its most recent low at $59.45 per barrel on June 5, a decline of 21.4% from the April peak on the continuous contract at $75.59. Crude oil was sitting not far off its low at just over the $62.00 level on Friday, June 14.

Price momentum and relative strength metrics in both WTI and Brent have declined into oversold territory on the daily chart. Open interest, the total number of open long and short positions in NYMEX crude oil futures declined from a high at 2.16 million contracts on May 1 to 2.063 million at the end of last week. Falling open interest and declining price is not typically a technical validation of an emerging bearish trend in a futures market. Increases in US production and inventories have kept the pressure on crude oil over the recent weeks.

Another week of inventory builds in the US

US daily production of crude oil has been running around the 12.3 to 12.4-million-barrel level, which is a record high. The United States is now the world’s leading producer of the energy commodity as daily output has surpassed production levels in both Saudi Arabia and Russia. Technological advances in the extraction of crude oil and higher prices have changed the dynamics of the energy commodity which are a far cry from where they were in past decades when the US was highly dependent on crude oil imports.

As production in the US has increased, so have inventory levels over the past two weeks. According to the American Petroleum Institute and Energy Information Administration, stockpiles of crude oil in the US moved 3.545 million and 6.8 million barrels higher respectively for the week ending on May 31. Last week, the API reported another increase of 4.852 million barrels and the EIA said that stocks rose by 2.2 million barrels as of June 7. The rise in oil inventories kept the pressure on the price of crude oil, which is still within striking distance of the recent low. During both weeks, the stockpiles increases were appreciably above analyst expectations. The one factor keeping the price of WTI above $50 and Brent north of $60 per barrel has been the developments in the Middle East.

New provocative acts in the Middle East

The Iranians have been following through on their promise to interrupt the flow of crude oil from neighboring countries in the region as sanctions have put a roadblock in front of their sales. On May 12 four oil tankers were sabotaged, and on May 14 a rocket attack hit a Saudi pipeline outside of Riyadh. Last week, on June 12, a missile from Yemen hit a Saudi international airport terminal causing multiple injuries. On June 13, two tankers suffered damage in the Gulf of Oman off the Iranian coast. US Secretary of State Mike Pompeo pointed his finger directly at the theocracy in Iran and told the world that the US would protect its interests and allies in the region. The temperature is rising in the Middle East, which is the home to over half the world’s oil supplies. Approximately 20% of the world’s crude oil flows through the Strait of Hormuz, which is a narrow passageway that separates the Persian Gulf from the Gulf of Oman. The Strait is a choke point when it comes to shipping for Middle Eastern crude oil heading for consumers around the world. While the price of crude oil remains under pressure, any hostilities that impact the production, refining, or logistical routes in the Middle East could cause supply concerns to mount leading to a price spike in the crude oil futures market. The news of the attacks on two tankers on June 13 lifted the price of the energy commodity last Thursday, and the bid remained in the oil market on Friday as the rhetoric continues to fly back and forth between Washington and Teheran.

Brent-WTI remains firm

The differential between Brent and WTI crude oil is both a quality and a location spread. When it comes to quality, WTI is a lighter sweeter grade of crude oil which means it has a lower sulfur content than Brent. WTI tends to be more desirable for refining into gasoline, while Brent is a better grade for refining into distillate products like heating, diesel, and jet fuels. The location component is because WTI is the pricing benchmark for US crude oil, while Brent is the standard for oil from Europe, Africa, and the Middle East.

The spread between Brent and WTI has widened because of OPEC production cuts of 1.2 million barrels per day limited supplies. At the same time, record US production weighs on the value of WTI versus Brent. However, the spread between the two benchmarks is also a barometer of political risk in the Middle East, which could be rising to a crescendo given the situation between the US and Iran over sanctions. Recently reports have been that the Iranians have begun enriching uranium in their quest for nuclear weapons which is likely to inflame the situation further.

Source: CQG

The daily chart of the price of WTI minus Brent August crude oil shows that the premium for Brent has increased from $5.87 on April 3 to its most recent peak at $9.75 on May 28 and was trading at $9.25 per barrel last Friday. The now expired July spread traded to a high premium for Brent at $11.59 per barrel in late May, which was the highest level since 2015. While the current premium for Brent is a function of OPEC production quotas and record output in the US, it also reflects rising supply concerns when it comes to Middle Eastern crude oil. US production is not going to decline anytime soon, nor is the problem with Iran, which could be on a dangerous path towards conflict in the world’s most politically turbulent region.

Trading in the current environment could offer the best opportunities – UCO and SCO for those who do not trade futures

At the end of June, the oil ministers of OPEC will gather in Vienna, Austria for their biannual meeting. The official OPEC meeting is currently scheduled for June 25 with the real decision-making session the next day with the Russians participating. The cartel will decide if they will keep the current output quota in place for the second half of 2019, which is a pretty good bet given the decline in the price of the energy commodity since April. The biannual OPEC meeting typically causes an increase in price volatility in the oil futures markets. At the same time, the tension in the Middle East could be highly supportive for the price of oil while the escalating trade dispute between the US and China threatens a global economic slowdown which could weigh on the price of the energy commodity. The bottom line is that the global economic and political landscapes provide a cloudy future for the path of least resistance for the price of oil, which is a prescription for lots of price volatility. On days when the trade dispute dominates headlines, selling could dominate trading. On sessions like last Thursday where provocative actions around the Strait of Hormuz or in the Middle East could send the price higher. In the current environment, trading rather than investing is likely to yield optimal results. The most direct route for long and short positions in the crude oil market is via the futures and futures options provides by the NYMEX division of the CME when it comes to WTI, or the Intercontinental Exchange when it comes to Brent crude oil. For those who do not venture into the leveraged and volatile world of the futures arena, the ProShares Ultra Bloomberg Crude Oil product and its bearish counterpart SCO provide an alternative. USO is a double-leveraged product on the long side of the WTI market, while SCO is a double-leveraged bearish product. The fund summary for UCO states:

The investment seeks daily investment results, before fees and expenses, that correspond to two times (2x) the daily performance of the Bloomberg WTI Crude Oil Subindex. The fund seeks to meet its investment objective by investing, under normal market conditions, in futures contracts for WTI sweet, light crude oil listed on the NYMEX, ICE Futures U.S. or other U.S. exchanges and listed options on such contracts. It will not invest directly in oil.

The most recent top holdings of UCO include:

Source: Yahoo Finance

The swap contracts with financial institutions and futures positions create the double-leverage on the long side of the crude oil market. UCO has net assets of $302.5 million and traders over 3.1 million shares on average each day, making it a liquid product. UCO charges an expense ratio of 0.95%. The price of nearby WTI crude oil futures rose from a low at $50.72 on June 12 to a high at $53.45 on June 13, a rise of 5.38%.

Source: Barchart

As the chart shows, UCO rose from $15.09 on June 12 to a high at $16.54 on June 13, or 9.6%, just under twice the percentage gain on the July futures contract on NYMEX.

SCO is the bearish product, and its top holdings also include swaps and futures contracts to create a double-leveraged return compared to the price of NYMEX futures on the downside. SCO operates conversely to UCO and has net assets of $88.98 million with an average of 2.8 million shares changing hands each day. SCO charges the same 0.95% expense ratio.

Both UCO and SCO are not medium or long-term investment tools. Instead, they are useful when it comes to trading the daily ups and downs in the crude oil market. With bullish and bearish factors at play for the rest of June, trading crude oil could be the optimal approach to the market that looks like wider daily trading ranges are on the horizon.

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