Oil prices have gone berserk in the past week. The May contract for West Texas Intermediate, which is the main oil price benchmark, plunged into negative territory on Monday. Like a game of musical chairs, oil price speculators were in a mad dash to unload oil futures contracts before they expired and had to take physical delivery of the oil. With storage space running out, they needed to pay a high price to exit these failed bets that oil would rebound.
Oil would rally from that bottom as speculators placed new wagers that the industry would solve its looming storage crisis with additional production cuts. One way some traders are gambling on that recovery is through oil price ETFs like the U.S. Oil Fund (NYSEMKT:USO). However, they're playing a dangerous game, since that vehicle could go bust if oil futures crater again.
With that and the oil ETF's other issues in mind, investors should avoid using it as a means to profit from a potential oil market recovery. Instead, a better bet would be to buy a top-notch oil producer like ConocoPhillips (NYSE:COP). Here's why it's a better option than the U.S. Oil Fund.
The financial strength to survive this downturn
Shares of USO have cratered this year because of all the volatility in the oil market. The fund has had to take several steps to stay afloat, including issuing all its remaining shares, approving a reverse-stock split, and planning to roll more of its contracts further into the future to avoid another implosion at the June expiration. However, it's possible that these moves might not be enough and that the fund might need to liquidate. That's what happened to the iPath Series B S&P GSCI Crude Oil Total Return Index ETN, which suspended new sales this week and will liquidate at the end of the month. If that happens to USO, it won't be around for a potential future oil price rally, which means holders will lose out on an opportunity to participate in that rebound.
ConocoPhillips, on the other hand, has one of the strongest financial positions in the oil sector. The energy company ended last year with $5.4 billion of cash on its balance sheet and another $3 billion in short-term investments. It also has one of the lowest leverage ratios in the oil sector. Meanwhile, it has quickly reacted to crashing crude oil prices by adjusting its operating plan. Overall, it has slashed its costs by $5 billion this year, which will help preserve its strong cash position. That enhances its ability to survive the oil market downturn so it can prosper when oil prices improve.
Lots of upside to higher oil prices
Whereas USO holds oil futures contracts that expire in the coming months, ConocoPhillips controls physical oil. That provides it with more flexibilit,y as it can leave this crude underground and wait until prices improve. It's currently taking advantage of that optionality by curtailing 225,000 barrels of oil production per day over the coming months, saving it for higher prices.
ConocoPhillips also controls an enormous amount of low-cost oil reserves. It ended last year with 15 billion barrels of oil equivalent resources with supply costs of less than $40 a barrel, roughly two-thirds of which it could produce at prices below $30 a barrel. That low-cost supply base not only enables ConocoPhillips to make some money as it produces crude at lower prices but also positions the company to cash in when they rebound. It can generate a gusher of excess cash at higher prices, giving it the money to return to shareholders via dividends and share repurchases.
USO, on the other hand, tends to see its value erode even when oil prices rebound, because of the costs of rolling its futures contracts. It often underperforms the price of oil as a result. Contrast that with ConocoPhillips' leverage to oil, which often enables it to outperform crude pricing during a market rebound:
Don't choose the wrong vehicle to play your oil hunch
The implosion of the oil market this year has investors starting to look out into the future at an eventual recovery. While it seems likely that oil prices could rebound in the future, USO isn't the way to play that thesis. Instead of buying a risky ETF that might not survive this oil price downturn, it makes more sense to invest in an oil company that has not only the strength to endure but also lots of upside to higher prices.