A popular trading device for the oil bears, the VelocityShares 3x Inverse Crude Oil ETN (DWT) has witnessed a 43% decline over the last 6 months as crude fundamentals have become much stronger. It is my belief that in the coming weeks and months, this trend is going to continue and the oil bears trading DWT will see additional pressure against their position. If you’re long DWT in hopes that crude will fall, it is time to get out of the trade as I see it.
Let’s talk about exactly what is happening in the crude fundamentals to get an idea of where we currently stand.
First off, crude inventories have started 2020 off with a moderately bullish note with recent weeks bringing the 52-week change in inventories below zero.
As you can see in the following chart, this really is only the first time this has occurred since the strong rally in crude oil in 2017.
When it comes to why this relationship matters, it is important to remember that changes in inventories are directly correlated to changes in price.
That is, if you can call the trajectory of where inventories are going to likely head over a certain time period, you can directly trade and make a profit from it. And the magnitude of the change in inventories is directly related to the magnitude of change in crude oil.
All this said, it pays to make sense of crude fundamentals and consider them carefully. So let’s start by giving the bears a break: crude oil demand has been fairly weak over the last year and we are heading into a season of general weakness in terms of crude runs.
This weakness in utilization truly has been a bearish factor in the balance in that all else equal, when demand is weak, price will likely drop unless supply adjusts as well.
There were many reasons for this weakness in demand in 2019 (weak cracks, economic slowdown, potential IMO 2020 retooling) and we could discuss this at length. But what tells me that we’ve likely returned to normalcy is just that: we are at the 5-year average level of utilization and we have been so for several weeks which indicates that the worst of 2019 is likely past and we can expect demand to simply be normal (to slightly tepid) going forward.
When we turn our attention to the other pieces of the balance, however, the trend turns bullish very fast. First off, exports continue to skyrocket.
There is no way around this – most of the production growth from the Permian is being exported globally which is bullish the U.S. balance because it means fewer barrels will go into inventories. This trend has continued for years and there truly is no reason to believe it will stop based on the fact that these exports are continuing despite volatility in the Brent-WTI spread.
What this tangibly means is that exports are going to continue growing in all likelihood and upwards pressure will be put on prices of crude oil in the United States as barrels are pulled offshore.
Now about that production growth… it’s actually slowing.
If you’ve missed the memo, Permian operators are defaulting and drilling activity is slowing.
The reasons are quite simple: the price of oil isn’t high enough to get cash flows positive so Wall Street has slowed the capital it provides to producers. This has led to operators bankrupting in the dozens and drilling activity plummeting. The simple fix here is higher oil prices. We need the price of crude to increase to get cash flows positive once again, and until this happens, supply is going to slow and prices will likely rise. It’s simple economics and a solid reason to not short oil.
And finally, OPEC cuts remain a sapping force in imports into the United States.
OPEC has gone through a few different meetings since late 2018 and the theme has always been to extend or deepen cuts. At its recent meeting, OPEC increased the magnitude of its cuts which will be in place through March of 2020 which will result in fewer barrels into the United States and tighter balances. OPEC’s explicit goal is a higher price of crude oil to help balance budgets of member nations – and with a production roughly equal to a third of global demand, it certainly has the capability to make this happen. It never pays to fight OPEC.
Do you spot a common trend? At best, there is only one variable of the balance which is not bullish and that is refining demand. Every other variable is bullish and indicative of dropping balances. Two of the factors (production and imports) are directly tied to powerful players demanding higher cash flows through higher prices. In a market like this, it makes sense to stay long crude oil and buying an instrument like DWT places you squarely against these fundamentals. It’s time sell/short DWT.
We can’t finish without talking about what DWT is and how it works. It’s a simple ETN which gives exposure to the GSCI Crude Index on a 3x leveraged basis. This index is provided by S&P Global and gives exposure to both Brent and WTI futures. And this means that you’ve got to factor in roll yield when considering your returns.
I don’t want this article to go too long, so I’ll keep it brief. Futures tend to converge towards the spot price which means that if you’re holding exposure in a back-month futures contract, you’re going to see your holdings either increase or decrease in value in relation to the price at the front of the curve. DWT is holding Brent (in backwardation) and WTI (moderate contango) which means that the overall roll of the fund is negative (it’s short an average holding in backwardation). In other words, since Brent is in much greater backwardation than WTI’s contango and DWT is short these futures contracts, you’re going to lose money holding a long position in DWT due to roll yield and the futures converging towards spot.
If that’s your first introduction to roll yield, I’d encourage you to read more about it here because it really is a big deal. For example, the United States Brent Oil ETF (NYSEARCA:BNO) outperformed the actual price of Brent in 2019 by around 15% simply due to roll yield in a strong backwardated market. Given the ongoing backwardation in Brent coupled with a recent pattern of moderate backwardation or weak contango in WTI, roll yield is going to remain positive and DWT is likely going to fall since it’s shorting the roll.
Based on the strongly bullish crude fundamentals and a positive roll yield in the underlying futures, it’s a great day to short DWT.
The underlying fundamentals are very strong with all but one element of the balance indicative of further strength and inventory weakness. Both production and imports are tied to players who are demanding higher prices and have the ability to ensure that higher prices are achieved. Roll yield in Brent and WTI futures has not been favorable for a long position in DWT.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.