Is UCO Going Back To $300? Very Unlikely
Every once in a while, I like to answer questions I get from readers beyond just the comment thread. It's usually because the questions, or some form of them, have been repeated by multiple people and it's an indication that there's a greater interest in a follow up.
If you've followed this site over the past two months, you'll know I've written about the oil market quite a bit. In particular, the United States Oil Fund (USO) and the ProShares Ultra Bloomberg Crude Oil Fund (UCO).
These funds were near death back in April when crude oil prices crashed and have staged a huge rally since oil prices recovered. Naturally, there's an inclination to believe that if the bottom is in and a recovery is in place that prices can simply return to the levels they were pre-COVID.
Obviously, that's not often the case.
In the current environment, the CBO estimates that it could be a decade before the U.S. economy can make up for lost GDP. The airline industry has been decimated and it could similarly take years for passenger traffic to pick up to where it once was. There's probably a desire to travel now that summer is here and restrictions are being lifted, but how many people are really anxious to get back into crowded places.
Optimism is understandable enough, but to assume things will magically return to the way they were is utterly unrealistic.
That's especially the case for the two oil funds I mentioned above. Both USO and UCO managed to survive the oil crash but they needed to do reverse splits and completely change their investment objective to do it. In other words, even if oil prices were to spike, these aren't the same funds they used to be.
I wrote recently about how Robinhood investors seemed to be losing interest in USO. These guys were no longer piling in as they had earlier in the year and ownership of the fund was stagnating. I also noted that interest in UCO, however, was still robust.
That brought out the oil bulls, one in particular who believed that UCO was about to go parabolic. I'll block the name to protect the innocent.
A couple things to note here.
First, it's always a nice to start with a respectful disagreement. I've received a far greater number of more direct comments than this one, and it's much easier to get my attention with this approach.
Second, I can what's stoked his fire. An 18% gain in a very short period of time usually gets people feeling confident.
Then he dropped his forecast.
For the record, UCO closed today around $28 a share. He's forecasting a 1,000% return over the next year and a half and a 300% return by the end of this year.
My simple response was this:
It's easy to dismiss something like this by simply saying the idea is nuts, but there are actual reasons why it's incredibly unlikely UCO is going to hit $300 by the end of 2021. Heck, I think it's unlikely to even hit $50, but that's another article for another day.
Here are the main reasons why I think UCO isn't heading to $300 (or anywhere near it).
One of the biggest reasons that USO and UCO crashed was their 100% exposure to the nearest-term oil futures contract. Even though they are considered the best proxy for current oil prices, these tend to be the most volatile.
Thankfully, USO and UCO began rolling out of the May contract just before it started imploding, but the funds quickly made changes to reduce their risk exposure. After a series of changes, they now own futures contracts with expirations as much as one year out into the future, while owning zero nearest-term contract at all.
The changes have reduced the funds' risk, but they've also watered down the return potential. Less volatility means less upside and because longer-term futures contracts are more thinly traded, transaction costs for establishing these positions tend to be higher as well.
And let's not forget that, while it hasn't used them yet, USO has the ability to buy non-crude futures contracts as well, including gasoline, natural gas and diesel fuels. So it's become less of a pure crude oil fund as well.
This is perhaps one of the most misunderstood parts of derivatives-based investments. When you buy USO, you're not buying oil. You're buying oil futures contracts. Most funds that use futures sell contracts just prior to expiration (so they don't have to actually take physical delivery of the commodity) and buy contracts with a new expiration date.
Those transaction costs, known as roll costs, eat into the fund's returns. And they're not cheap. Over the course of a full year, roll costs can amount to 20% or more. You've often heard that leveraged funds are appropriate for long-term holding periods and this is the reason why.
So even if oil prices are flat on the year, don't be surprised to see a fund like USO down 20%. This is probably the most significant factor that limits futures-based funds upside.
Of course, for USO and UCO to go up, oil prices have to go up. If you think UCO is going to $300, you need oil prices to go up A LOT!
Let's look at a very crude, no pun intended, example.
As oil prices bottomed, the July contract fell to around $18 a barrel (the May contract went negative, but other expirations stayed in positive territory). Today, the price of the July contract is around $37. So, it's roughly doubled in value.
During that time, UCO has gained 128%. For UCO to get to $300, it has to double not once, not twice, but three times from here. If you assume that since UCO is leveraged, it doesn't necessarily need to double three times, but it's probably not far off.
Even if the price of oil only needs to double twice for UCO to double three times, that means oil needs to get to $150 a barrel. Plus, it likely needs to get higher than that to account for short-term volatility and roll costs.
So let's call it $200 a barrel. Does anyone really think that oil is going to $200 a barrel at any point in our lifetimes, let alone over the next year?
No, UCO is not going to $300.
Like I said earlier, I think in a really good scenario UCO could get to $50, but I stick with my original forecast for oil funds. UCO has far exceeded my short-term target and I still believe they're pretty much fully valued here. There's not a lot of short-term upside potential left.
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