Analysts, economists and industry experts have been calling for a bottom in oil prices for nearly two years now. With WTI recently surging above its previous peak in late January, traders with long positions in the United States Oil Fund ETF (USO) and other are wondering if crude oil has finally actually bottomed.
WTI crude prices dipped as low as $26.05/bbl earlier in mid-February, prompting yet another round of bottom calls from analysts such as Tethys Partners analyst Bob Iaccino.
But how can USO investors feel confident in the latest oil price bottom call when each of the many calls in recent years has ended up wrong? How can you tell when oil prices have bottomed?
Here’s a look at what USO bulls should be watching to know for sure when the market has finally bottomed for good.
Speculating On USO
Unfortunately, calling an exact bottom in oil prices (and USO) in real-time, much like calling an exact bottom in the stock market or filling out a perfect March Madness bracket, is mostly luck. Sure, inevitably some people will time each market bottom perfectly, but they only look like geniuses when their guesses turn out to be right.
There’s nothing wrong with speculating on the bottom in oil prices, but there’s a long (and growing) list of USO speculators that have been wrong for nearly two years now.
Instead of watching oil prices, which are heavily influenced by market sentiment, volatility and the aforementioned speculative guessing, long-term oil investors should be watching the oil market fundamentals themselves for confirmation that the market has bottomed. Unfortunately, by the time the fundamentals confirm the nadir, oil prices will likely have already bounced off of it. But at least USO traders will know for sure that the bottom is in.
Oil Prices: Supply and Demand 101
Speculation in the oil market adds a lot of noise to what is, at its core, a simple supply and demand situation. Oil prices collapsed because the U.S. shale revolution majorly oversupplied the global market. OPEC decided they would compound the problem by ramping up production to drive down prices and run higher-cost U.S. producers out of the market. So far the strategy has worked beautifully for OPEC, as U.S. oil rig counts have fallen to their lowest level since December of 2009.
So here’s the first basic thing to watch when it comes to identifying a bottom in the oil market: global supply and demand. This chart comes from the International Energy Agency:
The good news for USO bulls is that long-term global demand growth is as strong as ever. Unfortunately, the market remains oversupplied at current production levels. The recipe for a stable oil market is for those blue bars representing crude stock additions to disappear. The recipe for a long-term rise in oil prices is for the blue bars to invert to negative territory for an extended period of time like they did from 2009 to 2014.
It’s important to remember that simply reaching a balance between supply and demand is not all that is required for energy prices to rise at this point. There is already a huge supply glut that must work its way through the market before any significant price rebound can occur. This graph shows how much crude oil the U.S. currently has in storage. In other words, this is a snapshot of the size of the famous glut.
U.S. crude stocks pushed above 2 billion barrels for the first time ever in October of last year and have so far peaked at 2.036 billion earlier this month. The numbers from the week of Feb. 19 showed a drop of around 5 million barrels. Unfortunately for USO bulls, one week does not make a trend. The most recent numbers from the week of Feb. 26 show another 10 million barrel surge to new all-time highs. When this number finally starts to drop consistently, oil investors will know the market has finally bottomed.
Takeaway on Timing Oil Prices
If you’re thinking that identifying the bottom in the oil market can’t possibly be so easy, it actually is. All of the guessing, speculation and volatility in oil prices have to do with trying to predict exactly when global supply and demand will reach a balance and crude stocks will begin to consistently decline.
In the meantime, USO investors will continue to suffer from the weight of contango in addition to slumping oil prices. Instead of USO, long-term oil bulls should consider investing in dividend-paying diversified oil majors like Chevron (CVX), profitable and market-leading oil services companies like Schlumberger (SLB) and well-hedged oil E&P companies like Memorial Resource Development (MRD).
As of this writing, Wayne Duggan was long SLB.
