Reader in San Francisco: I have seen two articles about younger investors playing the oil speculation game, specifically on UWTI and DWTI (leveraged oil ETNs). I’ll have to admit, its a pretty interesting consideration for the Robinhood slush account. How bad are these leveraged products and what is the decaying nature of them?
You mentioned two ETNs that go up and down based on the price of oil. I view them as I would view playing roulette at a Trump Casino, a complete gamble. If you want to be playing the oil speculation game, I’m actually OK with that. I would prefer readers didn’t use such complex products to do it. I’d also prefer a longer period of speculation than a day. Here’s a few ways that you could speculate in oil and why it might be a reasonable thing to do.
Why Playing the Oil Speculation Game Might Be OK
If you look at USO, an ETF that is supposed to follow the price of oil, you can see how far the price of the black gold has fallen. Crude has dropped by more than 80% going back to the mid 2000s when we had $4 a gallon gas. I’m a believer in long term mean reversion. When something goes way up, it probably will come down some. When something falls in price, generally it recovers over the long term.
The word I want to stress is long term. Over a shorter period, anything can happen. A single bad report could cause oil to fall 10%, and a single whisper of an OPEC oil ministers’ meeting could send oil up 10%. I would implore my readers to leave intraday oil price speculation to the professionals. Even they get burned all the time despite having access to the best information and fastest computers.
If you speculate on the short term movements in oil, you might as well spend your money betting on black in the casino. Who knows what oil will do tomorrow? I certainly have no idea. However, I have a strong belief that oil will go up in the next few years. The Middle East and its autocratic regimes depend on it. Saudi Arabia recently got downgraded by S&P because the country budgets for oil at a much higher price. Venezuela, Russia, Iran, etc. all depend on oil to subsidize their otherwise weak economies. With oil trading below $30, they are running through their reserves. Give it another year, and the required job layoffs and expenditure cuts could destabilize these unstable and unnatural regimes. In my view, the Saudis thought they could drive all the new entrants in the US fracking boom out of business by bleeding them dry for a year or two. Global economic weakness combined with this policy led to the oil collapse. OPEC countries have already started talking with one another to try and stabilize the price of oil. They need the price to rise though not just stay where it’s at. I’m betting that this happens. It’s not a sure thing, but I’m a fan of taking bets broad asset classes or commodities will rise long term when they’ve fallen a lot.
My Problem With Using Leveraged ETNs to Bet on Oil
Why I don’t like Exchange Traded Notes (ETNs) will have to be a separate post. Basically, an ETF (exchange traded fund) actually owns stocks or bonds. An ETN owns financial derivatives and is subject to the ability of a big bank to make good on its promises. If Vanguard fails, investors in Vanguard ETFs will not be ruined. However, if Credit Suisse failed, the owners of these oil ETNs would be totally screwed. If Credit Suisse can’t pay, then your bet is of no use.
An ETN buys derivatives that make bets on various things that could happen. UWTI bets on oil going up. DWTI bets on oil going down. Both promise 3 times the actual price movement in either direction. To do this, the company that runs these oil ETNs buys derivatives that reset. In the case of these oil ETNs, the reset is daily. For someone going into and out of the oil ETN that same day, the only costs you’ll pay is the pro-rated expense ratio, which should be less than 0.01%, and the bid ask spread. The bid ask spread is way more costly than the expense ratio here. The spread depends on how risky it is to buy and sell oil futures. That could result in you paying 1% or more of your money in fees to Wall Street for making a market in this arcane product.
If you leave your money in this ETN long term, you pay a steep >1% expense ratio. In addition, you pay for all the daily resets of the derivative contracts. Each time the ETN goes in and out of the contracts, it pays a fee. Sometimes this fee is really steep. Long term, this means you will almost certainly receive a lower return than what the index receives. In fact, it could be way less. In the case of the triple leveraged inverse oil ETN, the product could actually go bankrupt if oil fell enough.
Ways to Speculate Without Using ETNs
I think the best way to make an oil play is to invest in actual oil stocks. If you want close to 1:1 leverage you could invest in a massive multinational company like Exxon (XOM). If you want 2:1 leverage you could try one of the larger oil exploration stocks like Transocean (RIG). If you want the riskiest bet possible, then try looking at a smaller oil exploration company like Gulf (GLF). I own both RIG and GLF in my personal portfolio, and have been buying all the way down. I’ve also lost a lot of money. However, they used to pay dividends when things were good. If oil rebounds in the next year, I expect the market’s reaction to their reinstated dividends will be very positive and thus they will rise more than the price of oil. I don’t own Exxon because I’m taking a bigger bet on oil by investing in smaller and more risky stocks.
I like this method much better than using ETNs. I actually own something that’s real. The assets on some of these smaller oil companies books are supposedly worth 10 times the equity (I don’t believe that valuation but even if they sold it for 1/5 of what they paid they might make some money). I have tried to spread my bets among several oil related companies in case one or more go bankrupt.
I personally wouldn’t take too many big bets on oil falling. It’s not that it couldn’t go down more, it’s that you would need to use a more complicated product to make a bet on an oil drop. What’s more, oil will be needed for a hundred years or more, if only for the slow pace of emerging markets to adapt to new technology. Inflation will happen, and this inflation will hit oil eventually. Oil could keep falling, but after it’s fallen so badly and with many OPEC countries trying to keep the price up, only a global recession could knock the price down to the $20 a barrel people are predicting. It wasn’t too long ago that oil was at $50 a barrel. If oil moved in this direction, that’s a much bigger move up than the move to $20 a barrel would be a move down.
Playing the Oil Speculation Game is Fine if You’ve Got Extra Money to Burn
Rational speculation, ie a gamble with good odds, can be a smart thing to do. I don’t claim to know the future price movements of oil, but I think it’s extremely reasonable to think oil could recover in the next few years. That calls for a long time horizon on this speculation. You could even think of it as an investment. Make sure you have retirement and basic savings goals covered first before playing the oil speculation game.
I would prefer if you didn’t use the leveraged oil ETNs and other complex financial products out there. Unless you used to be a professional trader, these products are designed to make money off of you. On Wall Street, a trade is distinguished as being from “smart money” or “dumb money,” with dumb always being associated with individual investors. If you want to make a big bet, I’d use actual stocks. You can buy mega cap stocks like Exxon for a more stable bet, or you can take more risk with a smaller oil exploration company like the two I mentioned.
I have a lot of my portfolio in two categories that have fallen a lot recently: oil and emerging markets. I don’t try to get too fancy in my bets, I try to take significant positions when I have an opinion (ie greater than 10% of my portfolio), but I don’t bet the farm. If you make an oil bet, I’m fine with that. I’m even OK with a bet as large as 20% of your total portfolio, as many of these energy stocks still pay dividends. However, investing in ETNs, derivatives, call options, and other financial strategies is a little too exotic for my tastes and gives me worse odds as a non expert in those areas. I am playing the oil speculation game, but I’m trying to stay out of the areas where I do not understand the market very well. Use extreme caution when using financial products like leveraged oil ETNs that are made to be sold, not held.
Have a different view on the appropriateness of leveraged oil ETNs like UWTI and DWTI or other thoughts on oil? Comment below.
Fun fact: since I wrote this article , the stocks I suggested , RIG and GLF, are up about 55% and 126% respectively. The two have been an excellent way to gain leveraged exposure to oils positive movement.