Short Black Gold? Commodity Deflation

Oil production in North America is booming, crude oil today hitting new 4-year lows, and it is now beginning to have a huge impact on global hydrocarbon markets. In fact, some believe that the U.S. will eventually overtake Saudi Arabia and Russia as the world’s biggest producer of the key commodity, with some calling for the surge to happen by the end of the decade and OPEC is left if in a precarious situation.  If they cut production, prices may rise but they also risk losing customers to another provider (the U.S. or Russia).  If they do not cut production, prices will likely continue to fall due to excess capacity worldwide. 

This push towards energy self-sufficiency is largely thanks to the combination of fracking and oil shale, as previously unobtainable supplies are now being unlocked with relative ease. The amounts are so impressive that the International Energy Agency last year declared the production surge as a ‘supply shock’ that is causing ‘ripple effects through all aspects of the oil industry’.

There are also those who feel the U.S. is beginning to see the deflation and crude oil (and other commodities) would seem to signalling he's right.  While no one likes to see deflation (falling prices), it is beneficial to those who utilize those commodities when their input costs drop.  Lower gas prices is also a form of tax cut to the U.S. consumer, giving them more net income to spend within the economy.  Deflation in commodities will also force more M&A and closures as smaller players are forced out of the game and larger players take out their competitors in an effort to shrink the playing field.

Falling commodity prices also impact emerging market countries which produce and depend on their exports to support their GDP.  According to Citi:

“Our results suggests that a 10% decline in oil leads to 70-90bp lower rates in Brazil, Chile, Turkey, Korea and Thailand. Meanwhile, 10% lower oil results in 50-80bp higher rates in Hungary, Indonesia and Russia. But since lower oil leads to weaker EM exchange rates by and large.”

The CRB index (left) has been falling and you chartists out there may agree; it doesn't appear to be bottoming yet (mean reversion?).  Click on image to enlarge.

From a contrarian point of view, one may feel it's too late to short black gold but for those who day trade or believe the weakness will persist and see setups going forward, these are the names I would recommend.

Proshares Ultrashort Oil & Gas: ($DUG) Shorts oil & gas companies directly impacted by lower crude oil prices.

ProShares UltraShort Oil & Gas seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Oil & Gas Index.  Component companies include oil drilling equipment and services, coal, oil companies-major, oil companies-secondary, pipelines, liquid, solid or gaseous fossil fuel producers and service companies.

2x Short Oil ETF Choices

ProShares UltraShort DJ-UBS Crude Oil ETF ($SCO)

Easily the most popular in the short oil ETF market is SCO, a product that tracks the daily performance of the Dow Jones-UBS Crude Oil Sub-index. This approach gives twice the inverse performance, on a daily basis of WTI crude oil (see More Trouble for Oil Services ETFs?).

PowerShares DB Crude Oil Double Short ETN ($DTO)

For an ETN approach to inverse crude oil investing, consider the popular DTO for exposure. This product follows a benchmark of crude oil futures contracts with -2x exposure that rebalances on a monthly basis.  Thanks to this monthly rebalancing, the decay is likely to be less in the product, while it is also a relatively cheap choice in the space, coming in at 75 basis points a year in fees. While AUM isn’t that great for DTO-- $65 million—the volume is relatively solid at about 200,000 shares a day so this product should be quite tradable.

Other (less popular) short oil ETFs. 

A warning:  trading names with low volume can make exiting a trade riskier to get a fill price.

PowerShares DB Crude Oil Short ETN ($SZO)

This is arguably the least risky of the bunch, offering investors -1x short exposure to WTI crude. The ETN is rebalanced on a monthly basis though, so decay rebalancing issues are minimized, while it also adds in the yield from short-term T-bills as well.  The product charges investors 75 basis points a year for exposure, making it a relatively cheap choice in the inverse ETF market. SZO doesn’t have that much volume though, so bid ask spreads might be a little wide in this fund.

VelocityShares 3x Inverse Crude ETN ($DWTI)

This product is one of the riskier plays in the short oil market, utilizing -3x exposure with daily rebalancing. This is accomplished by following the S&P GSCI Crude Oil Index, which offers up exposure to WTI crude oil.  This note is also a bit on the pricier side, as costs come in at 1.35% a year, putting at the high end even in the leverage market. Additionally, volume and assets are quite low, so this might not be the most tradable note out there.

Bottom Line

The outlook for oil in the near term isn’t that great. Demand from key countries is quite sluggish while a strong dollar is keeping a lid on commodities as well.  Then, when you add in the incredible production statistics that are hitting the oil market, you get a great case to be bearish in the near term. Fortunately though, there are a number of ways to play this trend with ETFs, allowing investors to profit from a bet on a supply shock and lower oil prices in the near term.

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