COM - ERX: A Floor In Oil Could Send The Leveraged ETF Higher

2023-12-05 13:17:38 ET

Summary

• OPEC's recent meeting ended in a stalemate, with unchanged production quotas and a "voluntary" program for additional output cuts.
• Oil prices have declined due to Chinese economic weakness, but the U.S. is looking to buy at $67-$72 per barrel to replenish its Strategic Petroleum Reserve.
• The Energy Select Sector SPDR® Fund ETF and Direxion Daily Energy Bull 2X Shares ETF funds offer opportunities for investors to capitalize on potential increases in oil-related share prices, but timing and risk management are crucial.

Crude oil (CL1:COM) is the energy commodity that continues to power the world. While the United States and Europe are addressing climate change by supporting the production and consumption of alternative and renewable fuels and inhibiting fossil fuels, gasoline, an oil product, continues to power most automobiles and transport vehicles. Meanwhile, China and India, the world's most populous countries, have not signed on to climate change initiatives and continue to consume increasing amounts of petroleum, natural gas, and coal.

U.S. energy policy shifted after the 2020 election, handing increased power to OPEC, the international oil cartel. Since 2016, Russia has become its most influential non-member, cooperating with OPEC quotas, with production decisions a function of negotiations between Riyadh, Saudi Arabia, and Moscow.

OPEC delayed its late 2023 biannual meeting from November 26 to November 30 because of quota disagreements for the coming year. Saudi Arabia has shouldered the lion's share of production cuts and sought more cooperation and participation for the coming year. The meeting ended in a stalemate, with unchanged production quotas and a " voluntary " program for additional output cuts. However, the cartel members have a long history of cheating on quantities, which makes the meeting's outcome dubious.

Meanwhile, oil prices have declined as Chinese economic weakness continues to weigh on the demand. However, the U.S. is a significant lurking buyer below the market to replace its depleted Strategic Petroleum Reserve. If crude oil prices are close to a bottom at the $73.50 per barrel level on December 5, crude oil-related stocks are in the buy zone. The Direxion Daily Energy Bull 2X Shares ETF ( ERX ) is a leveraged product that turbocharges the returns from the leading petroleum-related companies. Leverage comes at a price, which is time decay. Therefore, timing is critical, and products like ERX are only appropriate for short-term risk positions.

OPEC discord sends oil prices lower - An opportunity

The first indication of conflict within the international oil cartel was its November 26 biannual meeting delay. In late November, OPEC+ will decide on production policy for the coming year. The negotiations are typically between Saudi Arabia and Russia, as Riyadh and Moscow are the two most influential factors.

Meanwhile, in 2023, Saudi Arabia shouldered the lion's share of production cuts, citing Chinese economic weakness as the reason for curtailing output. In late 2023, the Saudis were looking for help from other cartel members for the coming year, but many balked, causing the delay for the gathering to November 30. The outcome was cloudy, as the cartel agreed to keep production quotas at 2023 levels with a " voluntary " system for additional cuts. With a long history of cheating, the " voluntary " production reductions left the market dubious about any consensus over production policy for 2024.

Nearby NYMEX crude oil prices fell from over $95 per barrel in late September to the $73.50 level on December 5. The continuous February Brent futures contract declined from $97.67 to below $78.50 per barrel.

The U.S. is a buyer at $67-$72 per barrel

In October 2022, the Biden administration mapped out its plan for restocking the U.S. Strategic Petroleum Reserve after selling over 250 million barrels in 2022 and 2023 to control runaway oil prices. After Russia invaded Ukraine and oil prices rose to over $130 per barrel, the U.S. reduced its SPR from over 600 million barrels in late 2021 to under 350 million barrels. At 351.6 million barrels on November 24, the SPR remains at a four-decade low.

In an October 18, 2022, Fact Sheet , the White House stated:

" The Administration intends to repurchase crude oil for the SPR when prices are at or below about $67-$72 per barrel, adding to global demand when prices are around that range ."

Meanwhile, since issuing the Fact Sheet, the Department of Energy has already had plenty of opportunities to replace the SPR sales. In December 2022, March, May, June, and July 2023, the nearby WTI NYMEX futures price was within or below the target range. Over the period, the administration only purchased around four million barrels, a drop in the bucket compared to the sales. Meanwhile, crude oil prices have been trending lower since September 2023, but have not yet reached the target one for SPR purchases again.

Oil-related shares decline- The XLE has been trending lower since mid-September 2023

The S&P 500 Energy Select Sector SPDR® Fund ETF (XLE) is the most liquid traditional energy ETF product. XLE's top holdings include:

As the chart shows, XLE invests 39% of its assets in Exxon Mobil (XOM) and Chevron (CVX). At just under the $84 per share level, XLE had more than $37.5 billion in assets under management. XLE trades an average of over 18.2 million shared daily and charges a 0.10% management fee.

Lower oil prices have weighed on XLE since the September 2023 high.

The chart shows a 10.4% decline from $93.69 per share on September 14 to $83.97 on December 5.

ERX turbocharges XLE as it has a similar portfolio with leverage

The fund summary for the Direxion Daily Energy Bull 2X Shares ETF states:

ERX's top holdings include:

The chart shows a similar portfolio to XLE, with an over 38% allocation to XOM and CVX.

ERX magnified XLE's performance since the September 23, 2023, high. ERX dropped 21% from $71.58 to $56.51 per share, just over double the XLE's decline over the period.

Leverage comes at a price - Timing and price are critical for success

ERX is only appropriate for short-term risk positions on the long side of oil-related shares. Since ERX turbocharges the performance on the upside, it underperforms XLE and oil-related shares on the downside. Moreover, when share prices remain stable, ERX will decline because the options and swaps that create the gearing suffer from time decay.

In March 2020, when NYMEX crude oil futures were heading below zero for the first time, and the XLE fell to $22.88, the lowest level since August 2002, ERX tanked.

The chart shows that ER's leverage caused a one-for-ten reverse split in March 2020.

The chart highlights the value destruction caused by the reverse split, a warning that ERX is a trading, not an investing tool. Price and time stops are required for success when approaching crude oil-related shares using the leveraged product.

Meanwhile, Direxion offers a complimentary bearish ETF that delivers leverage when oil-related share prices decline. The Direxion Energy Bear 2X product (ERY) is less liquid than ERX. At $28.48 on December 5, ERY had $22.9 million in assets under management compared to ERX, which had $374 million in assets. ERY trades an average of 373,434 shares daily, while 479,293 ERX shares changed hands daily. ERY's expense ratio is 1.08%, while ERX's is 0.94%.

These short-term trading products allow market participants to position for higher or lower oil-related share prices. The leverage increases risks, making careful attention to risk-reward dynamics critical. Please be fully aware of the risks of leveraged products like ERX, including volatility drift and the possibility of outsized losses, before trading them.

In late 2023, I favor ERX with tight prices and time stops, as U.S. SPR repurchases could support energy prices over the coming weeks and months. Moreover, Saudi Arabia requires $80 per barrel to balance its domestic budget, and Russia and Iran need the highest possible oil prices to fund their military operations. Lower oil prices would likely cause OPEC+ to come together with defensive actions to increase the energy commodity's price. Finally, as oil-producing countries move away from U.S. dollar pricing, a decline in the U.S. currency is typically bullish for all commodity prices, and crude oil is no exception. The United Arab Emirates is reportedly asking BRICS countries to settle oil trade in local currencies, not the U.S. dollar.

ERX is not a buy-and-hold product and requires significant attention. I like to use ERX when I anticipate rising oil-related share prices, accepting short-term losses when stopped out because of timing in exchange for oversized gains when the share prices move higher.

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