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Guide to Leveraged Oil ETFs

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Oil remained the hottest commodity of 2016 with volatile trading seen throughout the year. Sentiments have now turned extremely bullish on the commodity especially after the Organization of the Petroleum Exporting Countries (OPEC) reached a historic deal yesterday to cap its oil production for the first time in eight years, at a meeting in Vienna.

The commodity jumped more than 10%, marking the largest one-day gain since August 2012, and smashed trading volume records. Brent soared to $52 per barrel while U.S. crude climbed to near $50 per barrel.  

The Deal: A Big Game Changer

The 14-member cartel, which accounts for one-third of the global output, will reduce production by 1.2 million barrels per day from the current 33.6 million barrels for six months starting in January 2017. Saudi Arabia, the largest oil producer, will bear the brunt the most with a cut of almost 500,000 barrels per day. The second largest producer – Iraq – which had previously resisted cuts, agreed to curtail production by 200,000 barrels per day. This was followed by output reductions of 139,000 barrels per day for United Arab Emirates, 131,000 barrels per day for Kuwait and 95,000 barrels per day for Venezuela (read: Oil ETFs Jump on Renewed Hopes of OPEC Cut).

Smaller OPEC countries also joined the league of lower production except Iran, which is allowed to boost production to 3.8 million barrels per day, slightly above its October level. Libya and Nigeria were exempted from the deal as they are already suffering from weak production due to unrest and violence. Meanwhile, non-OPEC member Russia, which is currently pumping at record levels, also decided to forego 300,000 barrels per day of oil output to prop up oil price.

As per the International Energy Agency (IEA), the oil market will regain its balance and shift from surplus to deficit very quickly in 2017, if the deal is implemented. It would then end the two-year crude-oil rout and stabilize the oil market. It will revitalize growth in the battered energy sector and lift the economies of oil-rich countries like Russia and Saudi Arabia.

The deal would end the two-year crude-oil rout and stabilize the oil market. It will revitalize growth in the battered energy sector and lift the economies of the oil-rich countries like Russia and Saudi Arabia.

Improving Industry Trends

While OPEC and some non-OPEC production is now expected to decline starting January, U.S. production has been on decline over the past few months. The U.S. Energy Information Administration (EIA) expects oil production to fall from 9.4 million barrels per day in 2015 to 8.8 million barrels per day in 2016 and 8.7 million barrels per day in 2017. In particular, oil production from the seven shale regions – Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, Permian and Utica – would likely drop by 20,000 barrels a day in December to 4.498 million barrels a day, the lowest level since April 2014.

Additionally, the latest inventory storage report from EIA has added to the bullish oil outlook. The data showed that U.S. crude stockpiles unexpectedly fell by 884,000 million barrels in the week (ending November 25) compared to analysts’ expectation of an increase of 636,000 barrels. Total inventory was 488.1 million barrels, which is near the upper level of the average range for this time of year (read: Oil ETFs: Short-Term Threat, Long-Term Opportunity?).

Coming to the demand scenario, oil demand rose for the second consecutive month in September by 2.3% from the year-ago level to 19.86 million barrels per day, as per the latest monthly report from EIA. According to the IEA, global demand is expected to ease somewhat to 1.2 million barrels per day this year after having peaked to a five-year high of 1.8 million barrels per day in 2015 due to slowdown in the OECD Americas and China.

Given a slower increase in global demand and decreasing supply, oil prices are expected to remain above $50 per barrel at least for the short term and could even rise further if oil supply falls more than expected. This has compelled many investors to turn bullish on the commodity at least for the near term.

How to Play?

For them, a leveraged play on oil could be an excellent idea as these could lead to huge gains in a very short timeframe when compared to the simple products. Below, we highlight a couple of products that could garner huge profits from rising oil price in a short span (read: Should You Buy or Sell Oil ETFs Ahead of the OPEC Meet?):

ProShares Ultra Bloomberg Crude Oil ETF (UCO - Free Report)

This fund provides a leveraged play to the crude oil segment of the commodities market. It seeks to deliver twice the return of the daily performance of the Bloomberg WTI Crude Oil Subindex, which consists of futures contracts on crude oil. It has $904.8 million in AUM and trades in heavy volume of about 8.8 million shares a day on average. Expense ratio comes in at 0.95%. The ETF gained 16.7% after the OPEC deal was sealed.  

VelocityShares 3x Long Crude Oil ETN

This is another popular leveraged fund targeting the energy segment of the commodity market through WTI crude oil futures contracts. It seeks to deliver thrice the returns of the S&P GSCI Crude Oil Index Excess Return and has attracted $1.2 billion in its asset base. Though the fund charges a higher fee of 1.35% per year, its average daily volume is incredible, exchanging about 20.5 million shares a day. UWTI surged 25.1% on the day.

Bottom Line

As a caveat, investors should note that these products are extremely volatile and suitable only for short-term traders. Additionally, the daily rebalancing – when combined with leverage – may make these products deviate significantly from the expected long-term performance figures (see: all Leveraged Commodity ETFs here).

Still, for ETF investors who are bullish on the commodity for the near term, either of the above products can be an interesting choice. Clearly, a near-term long could be intriguing for those with high-risk tolerance, and a belief that the “trend is the friend” in this corner of the investing world.

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