Why You Should Expect Continued Volatility in Oil

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March 17, 2020 11:50am NYSE:USO

NYSE:USO | News, Ratings, and Charts

  • Carnage in oil after the OPEC meeting
  • Saudis and Russians increase production
  • Kicking the US production while it is down- President Trump answers a week later

Crude oil is the energy commodity that powers the world. Addressing climate change by moving away from fossil fuels has yet to eliminate the demand for oil. Technological advances in fracking combined with regulatory and tax reforms under the Trump Administration made the United States the world’s leading producer of crude oil and natural gas. Meanwhile, the 2020 election in the US is likely to serve as a referendum on the future of oil and gas output starting in 2021. Low interest rates allowed oil and gas companies to take on unprecedented levels of debt at historically low rates. While production in the US continued to rise over recent years, the shares of energy-related companies lagged the bull market in stocks in a warning sign for the energy sector. 

As US production increased, OPEC’s ability to maintain stability in the oil market at the highest possible price faltered. As the trade war between the US and China threatened the Chinese and global economies, the international oil cartel cut production. On January 15, 2020, the US and China signed a “phase one” trade agreement that de-escalated the trade war. At the same time, Coronavirus emerged as a threat to the Chinese economy. In late February, the virus spread to areas around the world. 

OPEC had cut production from 1.2 million to 1.7 million barrels per day at its late 2019 meeting. Saudi Arabia kicked in another 400,000 barrels lifting the total reduction in output to 2.1 million barrels. The cartel agreed to meet in early March to assess the fundamentals of the oil market after the increase in production cuts. In the lead up to the meeting, the oil market expected OPEC to address the demand destruction caused by Coronavirus with an additional one million barrel per day cut. Saudi Arabia advocated for a more substantial 1.5 million barrel per day reduction. The United States Oil Fund (USO) and the United States Brent Oil Fund (BNO) replicate the price action in the WTI and Brent benchmark pricing mechanisms for crude oil.  

Carnage in oil after the OPEC meeting

Risk-off conditions began to impact markets across all asset classes in late February as Coronavirus spread from China to South Korea, Iran, and Italy. The price of nearby NYMEX crude oil futures had already probed below the $50 per barrel psychological level earlier in the month. During the week of February 24, the price fell through $50, like a hot knife through butter. Oil producers had hoped OPEC and Russia would address demand destruction at the March 6 meeting with a further reduction in output. While the Saudis were initially on board with lower production, Russia balked. The meeting ended without any agreement on quotas. 

Saudis and Russians increase production

The Saudis decided that they would abandon the previous deal and flood the market with the energy commodity. On Friday, March 6, the price of NYMEX crude oil futures traded to a low of $41.05 per barrel. The decline in the value of the Russian ruble made the price decline tolerable for President Putin, who gave the go-ahead to pump up the crude oil volume.  When crude oil opened for trading on Sunday night, March 8, the price gapped lower. As the $30 per barrel level gave way, the price traded to the lowest level since February 2016 as it reached a low of $27.34 per barrel, just $1.29 above the 2016 bottom.

(Source: CQG)

The Saudis and Russians decided to address the demand destruction caused by Coronavirus by flooding the market with crude oil supplies. As the chart highlights, the price action created a void between $36.35, the high for last week, and $41.05 the low on March 6. The same void is present on the weekly chart. The move by two of the three leading oil producers exacerbated the impact on Coronavirus on markets as the shares of US energy companies plunged. The low price and risk-off conditions have pushed many of the oil producers to the edge of bankruptcy, which could be the goal of the Saudis and Russians. 

Kicking the US production while it is down- President Trump answers a week later

US output peaked at 13.1 million barrels per day. According to the EIA, average daily production in the US stood at 13 million barrels as of March 6. The decision to increase production at a time when demand is falling off the edge of a cliff is an attempt to push the marginal US producers out of business. The landscape was ripe for this move as the shares of US oil companies had not participated in the stock market rally that came to a sudden end in late February. The bull market turned into a bear, and the oil stocks continued to underperform the market on the downside, thanks to the Russians and Saudis. With the price of oil at the lowest level in four years, demand weak, the stock market carnage and the future uncertainty over how many victims the virus will claim, the perfect bearish storm in crude oil deals the US oil patch a significant wound that OPEC hopes is fatal. 

On Friday, March 13, US President Donald Trump announced a state of emergency that released $50 billion in funding to address Coronavirus. At the same time, he instructed the Energy Department to buy crude oil for the strategic petroleum reserve. The news lifted the price of crude oil to $33.50 per barrel at the end of the day. 

It is not the first time that OPEC attempted to flood the market with petroleum to push marginal producers from the market. If that is the goal, the Russians and Saudis will need to endure a long period of low prices to force bankruptcies in the US. Meanwhile, the US is the world’s swing producer. Technological advances have made the US a lower cost producer that can turn the output on and off as the price moves higher and lower. The President’s announcement was a sign that the government is prepared to allow US output to fall and replace it with purchases at lower prices. However, the landscape could change after the November election as the opposition party’s embrace of the Green New Deal could also reduce the production of fossil fuels. 

Russia and Saudi Arabia could be making a wager that risk-off because of Coronavirus, and a flood of supplies will put the US oil industry to sleep. Going into the election, rising unemployment because of job losses in the oil industry to hand the contest to the opposition party. A Democrat in the White House in early 2021 would likely cause a substantial shift in US energy policy that would benefit OPEC and the Russians. Geopolitics crushed crude oil last week, but the game of intrigue is far from over. Iran continues to lurk in the background as a factor that could cause sudden rallies if hostilities were to break out in the Middle East. Expect lots of volatility in the oil patch over the coming weeks and months. When it comes to oil-related equities, US oil companies have a rough road ahead. Unless the US government views their survival as a matter of national interest, we could see massive consolidation and a flood of receiverships. Approach all markets with caution. Coronavirus presents an unprecedented environment of risk. 

The United States Oil Fund LP (USO) was trading at $6.07 per share on Tuesday morning, up $0.02 (+0.33%). Year-to-date, USO has declined -49.46%, versus a -6.52% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 109 ETFs in the Commodity ETFs category.

About the Author: Andrew Hecht

andrew-hechtAndrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.

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