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1 Risk That Oil ETF Investors Need to Watch Closely

By Matthew DiLallo - Updated Jun 4, 2020 at 5:17PM

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Oil ETFs like USO and UCO need oil to keep rallying to continue working.

Oil prices have been crazy volatile this year. West Texas Intermediate, the primary U.S. oil price benchmark, started 2020 in the mid-$60s. However, it crashed into negative territory in April as surging supplies collided with cratering demand, causing oil storage terminals to fill to the brim. WTI has since recovered from those lows, recently rallying into the mid-$30s.

Many oil market watchers believe that crude could have much further to run. That's causing speculators to pile into oil ETFs such as US Oil Fund (USO -3.11%) and ProShares Ultra Bloomberg Crude Oil (UCO -8.11%). However, there's one looming risk that could derail these oil trades.

Drilling rigs lit up at dusk.

Image source: Getty Images.

The bull case for oil price ETFs

The main reason speculators are gobbling up shares of oil ETFs like USO and UCO is that these vehicles attempt to track the price movements of oil. The stated aim of the US Oil Fund is to follow the daily price movements of WTI. Thus, if WTI rallies 10%, this ETF should rise by around that level. The ProShares Ultra Bloomberg Crude Oil ETF, on the other hand, should move by two times the daily performance of the Bloomberg WTI Crude Oil Subindex. Thus, if WTI rallies 10%, UCO stock should surge 20%.  

Traders who purchase these ETFs have bought into the thesis that oil prices have lots more upside. Fueling that view is the expectation that oil demand will rebound sharply. Several factors drive that outlook. For example, analysts believe that U.S. gasoline consumption could hit a record level this summer. Driving that forecast is the belief that people are less willing to travel by mass transit and airlines. Instead, they'll drive everywhere, including taking "staycations" to the beaches, lakes, and parks. 

That anticipated surge in demand comes at a time when OPEC and several non-member nations have agreed to a historic supply reduction agreement. On top of that, U.S. drillers reduced their output and drilling activities, which should keep a lid on oil supplies in the country. With demand surging, and supplies choked back, oil prices could continue rallying this year, which would fuel big gains for buyers of oil price ETFs.

The one thing that could ruin the whole trade

However, several oil producers see the recent rally in oil prices as an opportunity. For example, leading U.S. producer EOG Resources (EOG -2.01%) recently said that it plans to restart wells that it idled as a result of collapsing prices earlier this year. EOG Resources also said it expects "to really accelerate our production into what we see as a price recovery in the second half of the year." Other drillers are also restarting their shut-in wells and contemplating the resumption of their drilling activities. 

The risk here is that the industry could be getting ahead of itself. Oil demand has just started picking back up and might not hit record levels. There's an increasing possibility of a second wave of the COVID-19 outbreak in the coming weeks because governments are reopening their economies, and people came out in mass to protest police brutality across many cities over following the heartbreaking death of George Floyd. 

Meanwhile, OPEC's production reduction agreement remains tenuous at best. The group canceled a meeting scheduled for this week and might not hold one next week because not all members are holding up their end of the bargain. If members don't comply with the quotas, the deal might not curb supplies as much as the marketed initially expected. Meanwhile, news that U.S. drillers like EOG are restarting their wells and accelerating activity might also weigh on the organization's decision to extend its current production reduction levels further. None would see it as fair if U.S. drillers are the ones benefiting from their hard work. 

A risky trade right now

WTI rallied 88% last month thanks to the combination of production cuts and early signs of a rebound in demand. That helped pump up oil ETFs as USO jumped 37% while UCO surged more than 75%. This rally could continue to run as long as oil market fundamentals keep improving.  

However, with many U.S. drillers already restarting their pumps, it could act as a headwind for oil prices if they start flooding the market with oil again. Because of that, speculators need to keep an eye on how quickly the U.S. oil industry ramps back up because a rapid recovery in U.S. production could put pressure on prices and the value of these oil ETFs.   

Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

EOG Resources, Inc. Stock Quote
EOG Resources, Inc.
EOG
$112.19 (-2.01%) $-2.30
United States Oil Fund LP Stock Quote
United States Oil Fund LP
USO
$72.65 (-3.11%) $-2.33
ProShares Trust II - ProShares Ultra Bloomberg Crude Oil Stock Quote
ProShares Trust II - ProShares Ultra Bloomberg Crude Oil
UCO
$33.33 (-8.11%) $-2.94

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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