The announcement this week of the IEA Reserve Release of 60 million barrels of oil has put the prices of crude under some heavy pressure. Goldman recently decreased their 3 month forecast as well at: Goldman Forecast. Prior to this drop they still had a very bullish long-term forecast on Brent here. The current spread between Brent and WTI has dipped back below $15 recently, after historic spreads. Since 1990 WTI has spent more time selling at a premium than a discount to Brent, and never had a spread larger than $10. So putting the bullish 2012 Brent forecast together with a shrinking spread between Brent and WTI it seems that a drop in oil prices may not last too long.
Earlier this year I wrote an article debating whether USO was the right way to play rising crude prices here. It seemed that while an investor in USO could still make nice short-term profits from quick oil spikes, the slippage would be very difficult to overcome if it was to be held long-term. Below is the ratio of the price of USO to WTI throughout 2011. This illustrates both the consistent slippage of the ETF along with its inability to spike as quickly as oil during a price spike.
I also compared USO to WTI on a monthly basis, which shows through June 21st how the ETF was down almost 6% while WTI was still up 2.3% on the year.
| Date | USO Close | USO Return | WTI Close | WTI Return | Difference |
| 6/21/2011 | 36.79 | -9.16% | 93.70 | -8.76% | -0.40% |
| 5/31/2011 | 40.50 | -10.30% | 102.70 | -9.43% | -0.87% |
| 4/29/2011 | 45.15 | 5.99% | 113.39 | 6.78% | -0.79% |
| 3/31/2011 | 42.60 | 8.70% | 106.19 | 9.36% | -0.66% |
| 2/28/2011 | 39.19 | 1.50% | 97.10 | 6.72% | -5.21% |
| 1/31/2011 | 38.61 | -1.13% | 90.99 | -0.66% | -0.47% |
| 1/3/2011 | 39.05 | 91.59 |
| USO Return | WTI Return | |
| YTD Return | -5.79% | 2.30% |
See below that WTI has recently come very close to the 200 day moving average after spending the entire year well above it. A break below this level coupled with continued stock market weakness, European debt concerns, and high unemployment could send crude down to levels not seen since last summer.
Below is a comparison of USO to XLE in 2011. XLE is the SPDR Energy Select Sector Fund which seeks to replicate the Energy Select Sector Index. As of May 31st, 17.25% was held in Exxon (XOM) and 13.28% was in Chevron (CVX). Since oil stocks don't have a 100% correlation to the price of oil this fund may hold up better during big commodity swings.
For someone that wants to speculate on continued near-term oil weakness, a bear call spread on the August USO options may be ideal. This may also be a good idea for investors trying to protect a long oil position elsewhere in the portfolio.
USO closed Friday at $35.81. Currently USO is trading at about a .393 ratio to WTI. With the continued slippage, by August expiration this will likely drop to .39.
Below is a table of the August strike prices, and the current call and put prices. The "WTI" column takes the expected price of WTI to reach that price of USO (30/.39 = 76.92).
| August Strike | Call | Put | WTI |
| 30.00 | 5.85 | 0.34 | 76.92 |
| 31.00 | 5.20 | 0.46 | 79.49 |
| 32.00 | 4.35 | 0.62 | 82.05 |
| 33.00 | 3.60 | 0.83 | 84.62 |
| 34.00 | 2.87 | 1.11 | 87.18 |
| 35.00 | 2.23 | 1.46 | 89.74 |
| 36.00 | 1.67 | 1.90 | 92.31 |
| 37.00 | 1.21 | 2.44 | 94.87 |
| 38.00 | 0.85 | 3.10 | 97.44 |
| 39.00 | 0.57 | 3.85 | 100.00 |
| 40.00 | 0.38 | 4.65 | 102.56 |
A bear call spread of the $31/36 strike prices requires buying the $36 call for 1.67 and selling the $31 for 5.20 for a net cost of (3.53). The breakeven point is $34.53, with a maximum profit at $31 or below at expiration. Maximum loss is 1.47 if USO is above $36 at expiration. To add more upside to the position, a $36 put could be bought as well bringing the net cost to (1.63). So 10 positions of this would bring in cash of 1,163 (not including commission), and have a risk of paying out 5,000 for a loss of $3,837 when USO is above $36 at expiration. However, if it is at $31 then the puts will generate $5,000 along with the full $3,530 in the bear spread for a total $8,530 profit.
The above example is for someone really expecting a big short term drop in prices. Risking a loss of $3,837 for a gain of $8,530 could make sense for an oil heavy portfolio that may experience a significant drop if oil were to hit $75 in the next month. Or for someone that just wants to make a speculation on oil prices. For somone that expects oil to just drop below $85, the $33/38 spread without puts could be the right move. Net cost of (2.75) with a break-even at $35.75, or pretty much at Friday's close.
The longer the duration of a bear call spread on USO, the greater the chance oil may break out to the upside and ruin the trade despite the slippage factor. I have not heard many long-term bearish oil forecasts, but oil will likely continue to stay under pressure over the next few weeks. Keep in mind that the risk of a bear call spread will be greater than just buying a put,but the amount of the loss can be controlled by the strike price the long call is bought at.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in USO over the next 72 hours.
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