The Oil Trade is No Longer a Slam Dunk

In last year’s Note 17 of The Kelly Letter, sent to subscribers on April 26, 2020, I wrote an article, “Cheap Oil Will Become Expensive,” from which:

“The solution to cheap prices is cheap prices. …

“In the case of oil, last week’s negative price and this era’s persistently low prices will create a production wasteland as small players go out of business and big players shut down infrastructure. This will eventually meet higher demand, be unable to satisfy it, and send prices higher again…”

The Kelly Letter is not a trading advisory. These days, the only plans I actively manage in the letter are my automated quarterly Sig plans. However, in the unique window of opportunity opened by governments pausing their economies, I could not resist mentioning that there was no way oil would stay as cheap as it became at the end of April 2020.

Among other ideas for participating in what looked like a slam-dunk oil trade, I offered ProShares Bloomberg Oil 2x (UCO $65 +79% YTD).

Since then, the price of West Texas Intermediate has risen 300% from $16 per barrel to $64, and UCO has risen 293% from $16.53 to $64.92. People who bought UCO in late April or early May 2020 are now past the 12-month short-term capital gains tax zone. Many wonder if now is a good time to sell.

In my view, the case for a dramatic spike in oil price has greatly diminished from a year ago.

Oil is back to a normal price range, as the world economy reopens slowly, not in a rush that might overwhelm reduced production capabilities. OPEC and other producers look ready for gradually rising demand—such as it will be—if not a surprise demand surge.

The US may well hit the roads this summer, but it’s 4% of the global population. Europe still frets over Covid, along with Brazil and India, and even Japan is implementing selective lockdowns. Australian airline Qantas delayed its international service restart from the end of October to the end of December. I doubt we’ll see a worldwide all-clear that overwhelms supply and production to create an oil-price spike.

On the other hand, it’s hard to imagine what would send the price of oil meaningfully lower in the near term. The global economy will reopen.

Therefore, and as usual in trading, an incremental approach is probably best.

If you own UCO, consider placing limit sell orders to gradually reduce your position. This is my schedule:

My UCO Limit Order Sell Schedule
–  –  –  –  –  –  –  –  –  –  –  –  –  –  –

25% of position $65
25% of position $70
50% of position Later

Many people who benefited from this oil-price speculation plan to move capital from it into 9Sig. This makes sense, as the two ideas exhibit similar risk-reward profiles.

Conclusion: The oil trade is no longer a slam dunk. It’s wise to gradually reduce a UCO position.

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4 Comments

  1. Matt Kershner
    Posted May 28, 2021 at 11:55 pm | Permalink

    Hi Jason,

    Thanks very much for the follow-up on UCO.

    I would like to solicit an opinion from you and your membership on an unusual circumstance. The investment retirement plan that I am enrolled in (automatic salary deduction) does not allow me to invest in leveraged securities. However, in my ignorance, that is exactly what I did last year in the COVID dip. I am otherwise running the Sig plans (in light of the above restrictions). They have allowed my investments in UCO and GUSH (and MVV) to ride, but if I sell, I cannot get back in. I am only in my 50s, so I will not be retiring for 10 or more years. I did set a limit sell at $70 on UCO for 25% of my holdings.

    Thoughts?

    Matt

    • Posted May 29, 2021 at 11:14 am | Permalink

      Hi Matt,

      I would count your lucky stars on this one, and continue backing out of your leveraged oil positions at good prices. They are not long-term holds. It’s unfortunate that you can’t run 6Sig or 9Sig in your account, but you could run 3Sig or something close to it, which would be much better than levered oil for the long run.

      Jason

  2. Mark Morrissey
    Posted May 19, 2021 at 9:01 am | Permalink

    I always enjoyed your letter and thought I’d sign up again. I’ve modeled the 3% method through and through and in most extreme linear rises it will best the indices. Hope you’re doing well.

    Regards – Mark

    • Posted May 19, 2021 at 6:14 pm | Permalink

      Aloha, Mark. I’m glad you’re back!

      Yes, the Sig System will win in up markets, and when it trails in down markets, it’s usually busy putting bond money to work in stocks, coiling for another round of outperformance. This is evident in the wave patterns of the performance chart at the top of https://jasonkelly.com.

      See you Sundays,
      Jason



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