2023-09-05 07:50:03 ET
Summary
- UCO is a double-long instrument that aims to return two times the daily performance of the Bloomberg Commodity Balanced WTI Crude Oil Index.
- ProShares Ultra Bloomberg Crude Oil ETF is a high-risk, high-reward investment option suitable for short-term trades.
- Recent performance and momentum in the oil market suggest that staying long on UCO could be profitable.
Main Thesis & Background
The purpose of this article is to discuss the ProShares Ultra Bloomberg Crude Oil ETF ( UCO ) as an investment option at its current market price. UCO is a double long instrument, designed to return two times the daily performance of the Bloomberg Commodity Balanced WTI Crude Oil Index. This is a futures market product, so it may not directly follow the current price of crude, but I personally feel it is as good a way as any to access the oil market.
Generally speaking, this is a high-risk, high-reward investment idea and I suggest using it for short-term trades only. As a double-leveraged ETF, UCO is prone to big swings in both directions and this can cause anxiety for those who can't handle such swings. I bring this up as a disclaimer because while I am bullish on this idea (and have been for a while), I acknowledge it is not for everyone. Readers should always approach these funds cautiously because when the trade doesn't go your way, losses can pile up quickly. So approach double-leveraged funds of all stripes - UCO included - with managed expectations.
With that covered, let's talk about recent performance. I covered UCO a little under a year ago when I was bullish on it. There have been swings along the way but, over time, this option has indeed been lucrative for investors:
As we move closer to Q4, I wanted to take some time to see if it made sense to remain long oil futures or if it was time to take some chips off the table. After consideration, I see a bull case as the right outlook for the time being. Oil appears to have plenty of momentum and some important tailwinds that I think could push prices higher. I will discuss the reasons why below.
Momentum On The Side Of The Bulls
A central point for why I think sticking with UCO could be profitable is because the price action is heavily on the side of the bulls. In the first half of the year, oil struggled as recession fears (both in the US and abroad) dominated headlines. But as the world economy has proved more resilient and supply has been constrained, oil prices have rallied sharply in the past few months:
As you can see, since June prices have risen sharply. This is all-important for funds like UCO that utilize leverage. When the trend is your friend, these types of funds out-perform. By contrast, when losses compound, funds like UCO are the type of product you want to avoid. Fortunately, the bull case is the near-term story for now.
The takeaway for me is that as long as this trend stays in-tact then staying long UCO is the right move. Of course, we don't know what the future will bring, but this is precisely the right environment to be long a leveraged fund. If or when oil prices start to weaken, then it is easy to get out of this liquid of a product. But when I see consistent month-over-month gains like this it does not strike me as a time to take profits, but rather a time to keep enjoying them.
Labor Force Strength Supports Higher Prices
My next attribute supporting oil prices is the resilience in the U.S. labor market. As more Americans enter the workforce and stay employed, the more people there are commuting to work, traveling for work and leisure, and generally helping the economy avoid a recession. These are important macro-factors that tend to be heavily correlated with oil prices over time.
So, what are some of the "resilient" factors I am referring to? One is the change in payrolls have been positive each month this year. Another is that the labor force participation has been growing. This is especially true for the critical "prime-age" participation rate - essentially the people who should be working. This percentage has just reached a level not seen for twenty years:
The conclusion here simply is that a growing - or even stable - labor force is positive for energy prices. This includes crude oil. This is a commodity that is tied directly with economic health and the reality is the labor market is strong domestically. This is a supporting factor for keeping my buy rating for UCO in place.
SPR Level Suggests US Has Little Wiggle Room
Another bullish catalyst for crude prices has been a consistent theme coming out of the Biden administration. This relates to the Strategic Petroleum Reserves (SPRs) - or should I say lack thereof. In an effort to fight higher prices, this administration has been very liberal with draining these reserve. While I disagree with this premise inherently - that is irrelevant to this discussion. What is relevant is that the U.S. has a low level of reserves on a historical basis. This suggests limited room to use these reserves to try to cap market prices going forward:
Ironically, this tactic is probably more bullish for crude prices than bearish. The draining of the reserves means these barrels will need to be replaced at some point in the future. Since the futures market is forward looking, the future demand that will come from the U.S. government has a larger impact than the current selling of the supply. So it is very possible the Biden administration's actions here are actually a positive catalyst for funds like UCO.
Regardless, the reality is that this tactic has limited effectiveness in either direction. The amount of oil in these reserves are not overly meaningful on a global basis given current oil demand:
The point I am trying to convey here is not to be distracted by SPR noise. When there are announcements that the US is going to release barrels, that does not really change the demand-supply dynamic for two key reasons. One, the global demand on a daily basis dwarfs any meaningful outflow from the SPR in total. Two, this is existing supply that will one day need to be replaced when we have a more competent energy policy out of Washington. So if existing supply is just shifted around, that isn't much of a catalyst for price movements. So keep an eye on US, Canadian, and OPEC+ production , and not oil reserve movements.
UCO Has Diversity In Delivery Dates
I will now move to UCO's individual holdings make-up. Obviously, this is not a "diverse" fund in that its entire objective is to offer long-only exposure to crude oil. This is pretty basic and means that buyers of this fund want to have a bias towards higher oil prices. But it does offer portfolio diversification in two ways. One, the correlation with stocks is not direct and is often not very strong. This gives funds like UCO some real merit for someone like me that has roughly 70% of their net worth in stocks:
This tells me that crude (and UCO by extension) can offer a nice buffer for my portfolio, especially when the S&P 500 is feeling some pressure.
Two, UCO is not beholden to any one particular date for its futures contracts. The fund measures its contracts out with different dates - telling me that it can benefit from both shorter term and longer term movements in crude:
Of course, this poses a risk as well. UCO could see some of its holding rise due to short-term fluctuations, but that could be balanced out if the longer term outlook for crude is weak (i.e. if a recession is expected next year). So this is not wholly good or bad. But that is how diversification works. It can act as a hedge and protection - limiting both upside and downside. Given the fund's aggressive and leveraged nature, this helps to moderate some of the risk which in my view is positive.
The Bull Case Isn't A Hidden Gem
I now want to touch on some risks here. While I have laid out a buy case for UCO - and I do stand by that - I always highlight the ways a thesis can go wrong. This is not meant to be contradictory, but to give readers the full picture and help them make the most informed choice possible. Simply talking about how great an investment is without regard to downside risks is not truly helpful (or even ethical for that matter) and - with respect to UCO - risks definitely exist.
The first is one that I already touched on but will reiterate here. The make-up of a 2X leveraged, futures-specific ETF means that over time the roll yield and contagion effects can be very negative on the fund. As futures near their expiration date they can become worth less (or more depending on the outlook for crude). Fund managers, however, are forced to constantly roll over maturing contracts in to longer-dated ones - otherwise they would have to take physical delivery of the crude! This is not unique to UCO, as it impacts all types of futures ETFs, crude oil focused or otherwise. But it is a risk all the same and is amplified given UCO's leveraged positioning.
Beyond that, if oil moves in a negative direction, this fund will see double the losses on a daily basis, which can compound to greater losses if the downward trend stays intact. This can put the price action in a downward spiral that makes it impossible to recover longer term. Again, not unique to UCO, but a major risk. To see how it plays out, take a look at UCO's price movement in the long term, compared with a couple other oil futures ETFs that are popular:
What you see here isn't pretty. This confirms for me that these are short-term trading vehicles only. Do NOT use these for a standard buy-and hold strategy, as it should be clear why from the above graphic.
A second risk has more to do with timing at this particular moment. Personally, I see the opportunity here as a good one. But the problem is that so do a lot of other people. While that may sound counter-intuitive, I have often found that being a contrarian investor yields the best results. In the case of crude oil right now - that is not what the case is. In fact, if we look at options contracts, we see that investor sentiment has turned sharply bullish:
My takeaway from this is that oil's bull run has been bringing in a lot of investor interest. That could keep the party going, but it could also mean the risk-reward dynamic is not nearly as favorable as it was prior to this run-up. While I continue to see a buy case, I must manage expectations here but suggesting downside risk is also elevated given the FOMO trade that is building. Readers should weigh this carefully and not get themselves in too large of a position in this type of environment.
Bottom-line
UCO has had a nice push higher recently and I believe that could continue. The oil markets continue to benefit from bullish momentum, a resilient US jobs market which has helped the country avoid a recession so far, and tight supply globally. With OPEC+ having so far extended voluntary cuts put in to effect earlier this year, the demand-supply imbalance is unlikely to change in the near term.
All this adds up to likely gains ahead for UCO. The fund is poised to deliver twice the return of crude oil's price movements and that is exactly where you want to be if crude rally further. As a result, I am reiterating my "buy" rating on UCO and suggest readers give the idea some consideration at this time.
For further details see:
UCO: After A Slow Start, Oil Has Plenty Of Bullish Momentum Now