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Oil & ETFs: What Investors Need to Know

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The oil industry has been suffering the worst rout in many years. This is especially true as oil price has been in a freefall on a combination of excess supply and shrinking demand. In fact, oil dropped 24% to a more than 18-year low on Mar 18 with U.S. crude dropping below $25 per barrel for the first time. With the latest plunge, oil price is down 60% so far this year.

The coronavirus pandemic has resulted in a slowdown in worldwide travel and business activity that is weighing on oil demand. Additionally, the two powerhouse producers — Saudi Arabia and Russia — are preparing to ramp up production at a time when demand has weakened significantly (read: Global Oil Price War Begins: ETFs in Focus).

A number of analysts have warned about falling oil demand. Goldman said lockdowns to counter the coronavirus pandemic have raised the prospect of the steepest ever annual fall in oil demand. It forecasts oil demand to fall as much as 8-9 million barrels per day by the end of March and 1.1 million barrels per day in 2020. Rystad Energy is even more pessimistic, estimating a demand plunge of 2.8 million barrels per day in 2020 and 11 million barrels per day in April.

However, a wave of emergency moves by central banks against economic fallout from the coronavirus has led to some respite on Mar 19 with oil price bouncing back off their lowest levels. Oil made up for all its loses made in the previous trading session but is still in deep red from the year-to-date look. Even if the banks can provide enough stimulus or coronavirus vaccines becomes success, oil price could remain under pressure as supply remains a concern.  

The oil futures market is currently in a state of contango, where later-dated contracts are expensive than near-term contracts, for months. This signals that supply is rising and demand is falling, paving the way for drop in oil price. This trend is likely to persist at least in the near term.

Market Impact

The ultra-popular commodity ETFs that deals directly in the oil futures market saw terrible trading over the past month. United States Oil Fund (USO - Free Report) , which seeks to match the performance of the spot price of West Texas Intermediate (WTI or U.S. crude), dropped 58% while United States Brent Oil Fund (BNO - Free Report) , which provides direct exposure to Brent crude oil on a daily basis through futures contracts, plunged 53%.

The oil price crash has sent shockwaves across the energy sector, most specifically to American oil firms. The big oil companies like Chevron (CVX - Free Report) and ExxonMobil (XOM - Free Report) have warned of spending and cost cuttings. Occidental Petroleum (OXY - Free Report) slashed its dividend by 86%. Meanwhile, many smaller oil companies riddled with debt will be forced to lay off workers and consider filing for bankruptcy (read: Oil Firms May Cut Dividends Ahead: ETFs & Stocks in Focus).

As such, the SPDR S&P Oil & Gas Equipment & Services ETF (XES - Free Report) , VanEck Vectors Oil Services ETF (OIH - Free Report) and iShares U.S. Oil Equipment & Services ETF (IEZ - Free Report) stole the show over the past month, tumbling nearly 70% each.

While the collapse has hurt the oil producers and explorers, oil refiners have been less affected. This is because the players in this industry use oil as an input for processing refined petroleum products. Hence, lower oil prices expand margins for refiners, leading to rising stock prices. VanEck Vectors Oil Refiners ETF (CRAK - Free Report) , which is a one-stop shop for investors to play the oil refining market, is down 45.3% in a month.

Additionally, lower oil price decreased gasoline and jet prices resulting in increased consumer spending, which accounts for more than two-thirds of U.S. economic activity. The discretionary and retail sectors will thus benefit though they have been hurt by store closures and lockdowns due to coronavirus scare. The two popular retail ETFs - VanEck Vectors Retail ETF (RTH - Free Report) and SPDR S&P Retail ETF (XRT - Free Report) shed nearly 22% and 38.5%, respectively in a month.  

Apart from these, lower oil price is a boon to oil-consuming nations like India, Turkey and South Africa. After all, lower oil prices make up a big chunk of either tax revenues or GDP growth opportunities (and sometimes both) in big oil importing countries. Additionally, persistent weakness has made oil extremely cheap for the countries that import them. It will lead to an expansion in balance of payments, increase output and reduce inflation in these countries, thereby paving the way for overall economic growth. However, travel bans, and lockdowns have been hampering growth worldwide leading to sell-offs (read: Coronavirus Panic to Send Economy Into Recession: ETF Picks).   

iShares India 50 ETF (INDY - Free Report) , which provides exposure to the largest 50 India stocks by tracking the Nifty 50 Index, lost 34% in a month.

Leveraged Inverse Play

The persistent decline in oil price has resulted in huge demand for leveraged inverse ETFs as these could see huge gains in a very short time frame when compared to the simple products. MicroSectors U.S. Big Oil Index Inverse ETN YGRN and ProShares Short Oil & Gas DDG have more than doubled in a month and leading the inverse ETF space (see: all the Inverse Equity ETFs).  

The former is an ETN option providing inverse exposure to the Solactive MicroSectors U.S. Big Oil Index while the latter provides inverse exposure to the daily performance of the Dow Jones U.S. Oil & Gas Index.

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