Welcome to Trains.
I'm Joel Webber and I'm Eric bel Chernas.
Eric, we had plans for this episode, and then the situation in the Middle East, specifically around Iran, has continued to escalate, so we need to talk about energy.
Yeah. Oil.
What really got me thinking we should call an audible this week is USO. This is the oil ETF that has come back from the dead. Like three times, I swear I've written this thing off. Remember during COVID, it actually had futures that were about to go negative because nobody wanted oil reverse.
Now you've got this things up.
At least it was up twelve percent on this particular day, and before that I had gone forty percent in a month, and the volume was massive, twenty two billion dollars in a week, and it's been in the top five most traded ETF. So it's come out of its sort of grave to come back and take over. This is the kind of ETF that my friends from college will text
me about, like, oh, I want to buy oil. USO looks like the one, and it's the ETF we really made the whole traffic light system on because it's holding futures and they roll and it can be hidden costs in there and people it's like a wolf in sheep's clothing. But when it goes up, man, it really works. I think we should go over that, and then also alternative ways to play energy, because if you don't want to mess with derivatives, you got to go to the equity market.
So there's like XL XOP.
So when you want to play oil or invest in oil, or feel like you want more exposure to it, this is a perfect thing to cover on this podcast because there's multiple options and each have their trade offs.
You mentioned your traffic light system at Bloomberg Intelligence. What traffic light color are you giving this episode as we go into.
It, it's kind of the whole spectrum because USO is read XL and XOP would be green, although XOP gets one mark for being not market cap weighted. But yeah, I'll flashing everything. Yeah, that's why this is complex investing in oil. The bottom line is if you think about the thing you want to invest in, say a barrel of oil, think to yourself how annoying would this be to actually invest in directly? You have the bio barrel of oil somewhere, put it in your backyard.
It's toxic.
The more annoying and exotic it sounds, the more you're gonna have to deal with some frictions or things you don't like, like costs, and that's the case here.
So joining us to walk through these options. Vincent Piazza, who's the Bloomberg Intelligence Senior Industry analyst for energy, as well as James Seffert ETF analyst at Bloomberg Intelligence, this time on Train's the complexity of the oil trade.
James Vince Welcome Atrians, Thank you, thanks for having me. James, I want to start with you.
Can you break down why USO is, Like Eric said, it goes up and it comes down. What about how does this thing of structure that makes it so volatile like that?
Yeah, I don't this wording is going to sound mean, but it's called the United States Oil Fund and Eric said, it's the It's one of the primary reasons we went with the traffically because it's kind of like a wolf in sheep's clothing, like United States Oil Fund. Like it just sounds like, oh, it just holds oil. It's simple, and it's so much more complex than that, because, as Eric said, you've got to roll futures. It tries to stay as much in the front month as it can.
Typically we can get into what happened when oil went negative, which is going to be interesting to what's going on today, but it it it can change exactly what it's holding and when when when oil went negative, things drastically change exactly how the ETF was working. But what ends up happening is even if you think oil is going to go up over a certain time period, that's not what you're investing in. Everyone when oil went negative would would have taken the bet that oil was going to go
up from here. But you can't just make that bet in the markets, because the markets are smarter than that. They know that oil is likely to go up. In these contracts end every month. You need to trade each contract, so and if you're on the front month, you either got to get out of that contract or you have to take the delivery of the oil. And all of this just gets very complicated. So exactly why we're going to call this complexity of the oil trade.
And let me just paint a visual. If you're picturing futures right April, May, June, July, it goes out like.
A year picture.
The curve typically slopes up, so like as you roll from like April to May, you pay a little more for the next month. That is called roll costs. And this curve isn't in the state of contango. Now if everyone wants oil in an instant, the curve goes the opposite direction, so you actually pay less when you roll. That's where it's're at right now and USO obviously this is a good time to use it. But normally that roll costs when it's in a state of contango could
be anywhere from ten to thirty percent a year. So you could make a call that oil is going to go up in January and it goes up forty percent or thirty percent, and you basically are flat because of all the roll costs. That's why this is a wolf
in sheep's clothing. But because it does hold the near months right the month's closest to the actual barrel of oil, it does have a lot of sensitivity to the price today, so it does move very sensitively, and that's why the trading crowd likes it so decent trading tool, bad long term holding. Vince as an energy expert at BI, I know you cover the equities. Is that a fair assessment of the future's market in your opinion?
That is the I couldn't have said it any better. That is the perfect way of describing the difference between a tnentango setup versus a backwardation, which is what we have today. And because of the volatility, and also keep in mind at the back end is fairly illiquid, so the front end is more liquid. There's much more volume on the front end of the curve the back end.
Because of that ill liquidity or the less liquidity relative liquidity, you could see very very sharp changes in the underlying price of those contracts.
Okay, So, Vince, one of the things that I wanted to talk to you about was not that long ago, like weeks, it seemed like the world was in an oil glut, like there was more oil on ships than ever before. The price had been dropping. We were talking fifty dollars a barrel. Now it's like the reverse. How sensitive is the oil market to just disruptions and why is that?
So?
We have several significant choke points in the world, and the Shadehorn moves is probably one of the more significant choke points. Roughly twenty percent of LNG roughly eighteen nineteen called twenty million barrels of crude run through that particular very narrow passage, So a delay in transporting those molecules has a significant ripple effect across several other of the
choke points. That choke point, that very narrow choke point marries European supply, European capacity with Asian demand, so Middle Eastern supply running through that up to Europe down to Asia. That's a very significant choke point that could have considerable impact on balances, both in the short term and also in the long term.
One more follow Vince, because you're following this very closely and from a like you're looking at the investment side of it.
How long can this last?
Like is this something that it just seems like they're going to try to get the choke point opened as fast as possible. I mean, I'm sure, I'm sure that the pressure, especially if it hits you know, a price of gallon of gas, is going to be intense. So is this something that could last for a long time, or like I guess in this trade, is it kind of like one of those things that could reverse pretty quickly.
So the analog here that we have. The closest analog is twenty twenty two Russia Ukraine where Brent. Let's use Brent right. Brent is considered the global seaborn benchmark. Yeah, So we had Brent in February of twenty twenty two, spike to a peak in March and retrace by early two Q So it retraced that gain, that peak of flee from ninety to eighty to one twenty and then back down again to a ninety handle some time in April.
So it retraced very quickly. Now, in the case of the Strait of Hormuz and Iran in general, we want to look at three things. Right, I call it a delay, I call it disruption and destruction. Delay is the hydrocarbons get to their destination a few days later, we're not here. Disruption is I shut down a well, I shut down capacity because I fear that these barrels, these molecules can't get to their final destination. That's where we are now.
The destruction phase, where all bets are off global economies are severely impacted, is if assets are taken off the chessboard because of destruction, so that there is significant capital that needs to be invested to bring these facilities and bring this back up to snuff. So supply chain delays, maritime logistical delays, those are days. We're now in the case where we could see significant barrels off the market for significant periods of time, causing a collapse of the
global economy. Because we're staring at you know, not long ago it was one hundred and twenty being bid before the US market opened. We're staring at over one hundred dollars. That volatility is significant.
Let's say you know, we were college roommates. This is a cruise story, and I text you and I say, n listen, I'm not selling my Vanguard funds, but I want a little piece of this oil action. I want to make sure that I'm participating in all this craziness. I was looking at USO, but I don't know. I know you cover the stocks. What should I do? How would you answer that question to them?
You can start with this is not investment advice.
Yeah, yeah, yeah, yeah, yeah, yeah, yeah, No, definitely that's true.
I'm not trying to because we can't give investment advice. But I guess maybe as somebody who knows as much as you, just be interested to hear what you would say in terms of just somebody who wants to get more exposure to this market.
Yeah. So if you think about from a broader perspective, you have the ETF complex. The xl E is probably the broadest, the most liquid, the cheapest form of exposure across the equity energy space. But that exposure encompasses not only the upstream but also the downstream the extream components, so it gives you what I call the energy value chain.
So you you like that vehicle as just like a proxy for.
The energy exactly exactly because within within that ETF as both James and Eric No. Three names make up the bulk of that exposure. And those are the integrateds. You have Exxon, Chevron, and you have what I call a mega independent like Conicgo. They make up the bulk of that exposure. So they have exposure across not only the upstream side of the business so the extractives right the EMPs, but also have downstream downstream refining and also petrech chemicals.
So that provides you with the value chain exposure. As you get more granular and you think about the EMP space, the XOP is an area that that we've discussed in the past. But the XOP or the US Oil and Gas e M P ETF, which I think is I EO, they're not pure proxies for the upstream exposure because they too have much more broader exposure to the downstream and
also some LNG components. Really, when you think about the exposure and what tends to do well in instances like this, it tends to be that downstream side, right, because as prices go up, the refiner's reprice to the consumer at the retail level the gas and diesel that go into on road vehicles, and so that price tends to come across pretty instantly. But when price is revert at the wholesale level at the crude level, prices at the pump
don't correlate as quickly. So in the refining space, in the downstream space, you have probably one of my favorite ticker symbols of all time. C R a K. You guys can pronounce it for me.
Vince wrote a which is basically an introduction to stocks. Usually he wrote one for xl E and in it I'm reading it and I could tell he he loves crack Joel, because I'm like I'm like, Vince, why don't you just why don't you just say you love crack in the headline.
I mean, that's really what's going on here.
Okay, So talk to us about about the ETF crack. Vince.
Yeah, So it provides you with pure play downstream exposure. When I mean downstream exposure, the upstream side are the companies that extract the hydrocarbon. The downstream the refiners are the companies that refine the product, the raw material, the feedstock into the things that we use. So the gasoline and diesel that cars and trucks and vans used in
there every day. Now, as spreads widen, there is an outside its profitability that ends up in the hands of the refining companies and most likely for longer, even after the price reverts. So it is a pure play exposure to the downstream. The reasoning being that you have margin expansion and higher profitability for longer as this crisis persists for longer, you also most likely have what I would call a geopolitical risk premium that remains in the commodity for longer as well.
Eric, to bring in just a little bit of flows and comp between the ETFs, we've talked about so far, like what's the action look like for this suite of ETFs in the energy space.
Yeah, so he went over I think four of the big ones, maybe five, but XALE is the king. It sounds like from what Vince is saying and what I would you know.
Also, Echo is like.
You can't really get too hurt with XL. It holds a lot of stocks, it's diversified. The only thing is just it's not going to have the sensitivity to short term moves and oil Like if you look over the short term, USO is blowing away XL in the past like week or month, but XLE is up like one hundred and sixty eight percent in the past ten years something like that, and USO is like down. So it's that rolling of the futures that makes USO almost like a hot potato. You cannot hold it for longer, We'll
just eat you alive. XLE you can hold for longer. So I think that's the main takeaway. And then x XCS they're going to have like more specific parts of the oil industry, so it's like almost like a subsector.
Like a specific niche bet.
But if we look at this year, the number one ETF by flows as xl E with five billion. Number two isn't even a billion.
I funny.
Number two is u ur a uranium jool even though that's t energy. Vd XOP is fourth. Oi H is another one. So I guess you know this is part of the dilemma. I'm want to go to James on USO. James, obviously holding these equity ETFs is monitored. You know, That's why these equity tfs get a green lightner system. They're diversified, they hold equities. They have obviously some sensitivity to oil, but not like USO. Now, can you go over USO a little bit here? It came out in like twenty
years ago. It rolls futures, and then during COVID futures were about to go negative, and I think it had to like it was going to owe people money or something, so it had to like switch strategy to holding all of these different futures across the curve so that it wasn't like just holding the near month. And then I guess it switched back. Can you go through the story of USO, because honestly I wrote it off I thought it had become neutered by holding all these months, which
gives it less teeth and less sensitivity to oil. But I guess it went back to its front month exposure.
Yeah, that's exactly right. So what happened Oil went negative or was going negative. Things were going bad because the government the world was shut down due to COVID And what ended up happening really there was a few big drivers. One, they were heavily in the front month and second month contracts, which is what this product does, and they were not
doing well. The other problem was the ETF was this was a case sometimes ETF's like there are a fish that gets too big for the pond that they're in, and in this case, USO owned like well over thirty percent of the contracts with the open interests of the futures that were getting exposure to the oil contracts. It was basically the tail wagging the dog, and the SEC
was getting concerned, the CFTC was getting concerned. They had to go in and break, like bake the rules that they basically had and are in their perspectives saying what the fund would do, because all of a sudden, you have all this money in this fund that's holding this contract and it's all gonna flow out because it rolls to the next month contract like it's set to keep rolling, and all of a sudden, you're gonna have a ton of money pour out towards the end of this contract.
It's already heading negative, so they're gonna dump more of these contracts onto the market as it's negative. ETF can't go negative. All these problems were happening. So what they did is, as you said, they went to all these other months. They went out twelve months essentially, so they went from we have high octane exposure to what's going
on in oil right now, to we own the entire curve. Essentially, we own the curve out one year and so one a lot of investors who were trying to bet on oil rebounding all of a sudden didn't have a bet on oil rebounding because they were just bet across the curve. And the funny thing is the Unit US Commodity Funds actually has another fund that does this already. It's called USL and it holds the twelve month contracts. So essentially the USO started mirroring its it's sibling of USL, and
it wasn't great. It took a few years. But in twenty twenty three, I believe they started moving back from the twelve month contracts just to the front two months, and I yeah, so this all happened. It was kind of crazy in twenty twenty three time range, but they got back. By January twenty twenty four, they were in the front and second month contracts.
Okay, So change in strategy there. That brings us back to basically being like this thing was originally right. So we'll be curious to see how this one plays out since it's so volatile.
Yeah, I mean, looking you're to date, USO's up fifty seven percent, UNL is up two percent. So but if you went back, UNL would have probably gone down less. It also doesn't have as much role costs. But honestly, here's my take. If you're looking for quick sensitivity and a short term trade, I mean, USO will do the job, but you can't hold it. You just you can't hold two things long term. You can't hold anything that rolls futures, and you can't hold anything has leverage.
You have to treat it like a chainsaw.
Or juggling the chainsaw.
Yes, XL XOP.
These are diversified ETFs that you can sort of bolt onto your portfolio as if you're you know, one of long term overweight to this sector.
I notice you didn't mention crack when I asked you about, you know, Tom Screen, but you want.
To talk about there's also frack. You want to like siblings crack and crack. So yeah, I mean, look, crack is a very specific oil refiners. Vince's case is good to me because you you can go out and speculate and try to drill the oil, but you have to refine it. So the refiners are kind of like in a sweet spot of like you have to come through us anyway, and that's a good spot to be in.
I guess it just depends on and also, I think the more you get to subsector ETFs outside of xl E, the more you are not overlapping your regular portfolio because a lot of people own VOO and a lot of XL's top holdings are in VOO already or IVV or SPY. The more you go to subsectors, the more you're getting unique exposure that we call portfolio completion. So I think crack is a you know, a good novel choice for
something that's like, you know, not the obvious one. We try to do that when we write our notes too, is like here's the big one, here's the cheapest one, and here's sort of like a wild card you might not have thought of.
Okay, another wild card that I wanted to bring.
Up, the Breakwater ETF.
Yeah, talk about that one.
Yeah, because Vin, you know, Vince, we're talking about stuff that's industry specific. But then there's gonna be the stuff that's sort of like peripheral.
Right, so on the I didn't even know this existed.
Sometimes, I you know, there's forty eight hundred.
I was, you got to know these.
So this is called the Breakwave Tanker Shipping ETF.
Oh it said breakwater, Breakwave, breakwave.
Yeah, and the ticker is be WET. And the day after the Iran do you.
Know this one? Do you know what it holds? No? He says no, James, you know, of course, you know?
Well he was I do know, now, Yeah, okay, I knew what be dry was, but I didn't know what the UT was until this till the last couple of weeks.
The day after the Iran strikes, which would be Monday, the second of March, it went up twenty eight percent. That is insane for a non leveraged DTF. I mean that is unbelievable. One day, Chang, Yeah, it went up more than USO, went up more than anything I could see.
It was perfectly positioned. Okay, what does it hold.
It basically holds these tanker futures that are linked to shipping oil from the Middle East to Asia and Europe. So I'm like, this is it's like they literally made it for this situation. It's a little dark thinking something's going to benefit from war. I don't want to go too heavy into this, but this was custom made for this.
Now it is so crazy sounding. Though the volume was nowhere near what we saw in USO, it did trade about fifteen million dollars, which is pretty good for a real exotic ETF like this, But the average Joe Degen is going to use us so this is just probably even a little too crazy for them. James, what can you tell us about this that we might not know?
You hit most of it. I mean, the way to think about this is its futures contracts. So like you said, on shipping to Europe, Middle East, it's really basically the futures contracts on those actual tankers, think those massive, massive ships that are holding the oil and whatever other hydrocarbons
as Fins talked about. And then the flip side, the bee dry one was one that we talked a lot about with Russia and Ukraine, and that's going to be holding you know, dry goods, whether that's commodities like agriculture and mining materials and things like that. So they're kind of like twins or same side, different sides of the
same coin. But b wet is these futures contracts on these massive shipping oil tankers, most of which are sitting right now in that canal waiting to go by in the strait of her moves.
And by the way, you know this idea that like polymarkets, like oh all these degens can bet onto it's too crazy. I mean the honestly this future is called Middle East Gulf to China.
I'm sorry. The institutional world is pretty degen.
When it comes to betting on stuff. I didn't even know there were futures.
I mean a lot of it is like they're using it for hedging purposes, like a lot of these ships. One of the huge things that happened is like their war insurance stopped, and basically because anybody who's offering that insurance can give a notice of like a certain days beforehand and they can pick up insurance again and then they have to pay more for it. So war insurance now is like five x what it used to be just before everything happened here. So all these things are
just hedging insurance. It's this is all it is, and you can everything is financialized.
Vince. I know Vince.
I work with him a lot, and his out is filled with earnings calls, like literally from like six am to like six pm of all these energy companies. So you clearly have your ear to the ground in terms of what they're talking about. What do they think of something like this, Like if you're in the energy industry, is good, bad, and different?
What's the vibe there?
So I can tell you from our conversations with the management teams that they look at this with a great deal of caution, right, because you're now at a point where you're in the realm of demand destruction and that is very bad. Okay, when you sell a product whose price is so high that it reduces the amount of consumption or it creates that inflationary pressure across the value chain.
That's bad when you think about prices along this curve. Right, we've seen the front end of this curve pop. The back end of the curve, let's call it the second half of the year, that's averaging somewhere around eighty bucks or so. What you're likely to see from operators over the course of call the next earning season is layering on additional hedges. And what's a hedge. It's risk protection. I am selling my output forward, I am receiving a price,
a confirmed price. It creates transparency for me, it creates cash flow, It protects my drilling program. Okay, and I think that's what the operators are looking for because the investor base, what you all have told them is I do not want to see production. I do not want to see capital being invested to grow output. What I want is the return of free cash flow. What I want to see is better balance sheets. So the operators have right size, there are balance sheets in this environment.
Since twenty twenty two, they've gotten their financial leverage down. Free cash flow is relatively robust now, and so you're seeing distributions. You're seeing distributions of what we consider based it ends, and on top of that supplemental distributions, so the capital is coming back to the investors. That's what you all have said. You all wanted, we don't want a production So I do not see any I shouldn't say any. I would be surprised if we were to
see an acceleration of production growth in this environment. What I will see, what is likely to occur, is an increase in the amount of hedging over the year twenty twenty six because of a way not only the front of the curve has responded, but also the back end of the curve, most recently, granting these operators an opportunity to slap some additional hedges on, protect their chilling programs, and grant them some incremental free cash flow to give back to all of you.
A hedge feels like the perfect way to end this episode. Thanks James, thanks so much for.
Your time, Thank you, thank you for having me, Thanks for listening to trillions.
Until next time. You can find us on the Bloomberg Terminal, Bloomberg dot com, Apple Podcasts, Spotify.
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Hit us up on social I'm at Joel Weber Show He's at Eric Balcino's Trillions is produced by Magnus Hendrickson