We had recently forecast that crude oil is likely to rally to $68 levels in 2018. If proven correct, the trade offers a gain of about 31% from current levels. However, holding crude oil futures for the long-term is a risky proposition, best suited for crude oil producers who use it as a hedge.
Key points
- We expect crude oil prices to rally
- Tax reforms are likely to be positive for energy companies
- XLE is likely to be the best bet to ride the upcoming rally in crude oil
For small traders, crude oil futures are best traded on a short-term basis. So, is there any other way we can benefit from the forthcoming rally in crude oil?
Yes! We can either use individual stocks or the ETFs to benefit from the appreciation in crude oil prices. In this article, we will focus on the ETF that will give us the maximum bang for our buck.
All ETFs are not created equal. Therefore, their results also vary accordingly. We will consider and compare the three popular oil ETFs – USO, USL, and XLE. We shall provide a brief overview on all the three and then choose the one most suitable for us.
United States Oil Fund LP (USO)
This is one of the popular oil ETFs used by traders for short-term trading. It has $2.27 billion assets under management and has been in the markets for more than 11 years. It holds the near-month derivative contracts of oil, rolling them over to the future months once they expire.
This results in a huge roll over cost, due to which, in the long-term, it usually underperforms oil by a huge margin.
It has a decent average daily volume of $170.53 million. Therefore, the spread is unlikely to eat away into the trade. However, due to its huge underperformance in the long-term, this will not solve our purpose.
United States 12 Month Oil Fund LP (USL)
USL tried to mitigate the negative of USO by dividing its assets over twelve months. It holds futures contracts of the upcoming 12 months. Once the current month contract expires, a new position is opened which is 12 months out.
However, this has not become very popular with traders and its total assets under management are only $96.5 million with a daily volume of $1.06 million.
Energy Select Sector SPDR Fund (XLE)
The third popular ETF is XLE. This, however, does not invest in derivatives like the two mentioned above. The fund invests in top energy companies listed in the S&P 500. Therefore, it doesn’t track crude oil futures directly, but, usually, when crude oil prices rally, so do the energy companies.
XLE has $16.41 billion of assets under management and is the most liquid of the three, with average daily volume of $723.93 million.
As this owns large oil companies that are known to pay a good dividend, the investors can get additional income while holding it for the long-term.
A comparative study of the three ETFs
Let’s compare the performance of these ETFs with that of crude oil and see which one mirrors the crude oil prices in the long-term.
5-year comparison
Over the last five years, XLE has been the best performer, even beating the underlying asset by a huge margin. While crude oil is down 39.28%, XLE has only fallen 6.13%. USL has fallen 51.34%, while USO is the worst performer with a 66.84% fall.
However, we don’t plan to hold for that long. Our time frame is just over a year. So, let’s compare the performance of the ETFs from the lows of February 2016 up to now.
From the lows of February 2016
From the lows of 2016, both USO and USL have generated about 31.65% returns for their investors, compared to the 91.58% returns in crude oil. XLE, however, is the laggard, having produced only 24.88% returns.
XLE is likely to regain its sheen soon
The plunge below $30 a barrel levels in 2016 really sapped the sentiment in crude oil. The companies were struggling to stay afloat. Though the companies are not selling oil at a loss at the current levels, they are only managing a small profit. However, if crude oil rallies to above $60 a barrel levels, these companies will earn more profits.
The energy sector is the second-worst performer in the S&P 500 in 2017. As a result, this is under-owned, but we expect the interest to return once crude oil is able to breakout and sustain above $55 a barrel levels.
An additional tailwind to the energy companies is the passage of the tax reforms. President Trump and the Republican party are likely to put their best efforts to pass the tax reforms at the earliest. After all, they have not been able to claim any legislative victory since President Trump took charge of office, though they are in a majority in both the Senate and the House.
How much will the energy sector benefit from the tax cuts?
JP Morgan believes that along with tax cuts if one considers the immediate expensing of capital expenditures, energy sector stands out to benefit the most.
Therefore, dual benefit from higher crude oil prices and the tax reforms is likely to bring back the interest in the sector. Once money starts pouring into oil stocks, XLE is likely to gain momentum and offer attractive returns.
Let’s look at the charts and try to find the best entry and exit levels for XLE.
What does XLE’s chart forecast?
XLE is in a long-term downtrend, however, it is attempting to form a base around the $60 mark. Once the ETF breaks out of $70 levels, it is likely to rally to $78.45 levels, the highs made in mid-December of last year, just days after the OPEC production cut deal and about a month after the US Presidential elections.
However, if crude oil prices rally to about $68 a barrel levels, we believe that XLE can reach $84 levels and higher, a level last seen in 2015 when crude oil prices were closer to $60 a barrel.
Let’s determine the entry and stop loss levels from the daily chart.
XLE made a yearly low on August 21 and has since then been in a sharp pullback. For the past few days, the ETF is in a consolidation, digesting the sharp gains. It has been sustaining above the 23.6% Fibonacci retracement levels of the rally from $61.8 to $68.93, which is a bullish sign. If this level breaks, the next supports are at $66.21 and $65.37, being 38.2% and 50% Fibonacci retracement levels.
We expect XLE to find support between these two levels. Therefore, we want to buy 50% of the allocation at the current levels and buy the next 50% on dips to $65. Once the ETF breaks out of $69, it should rally to $75 levels. Our initial stop loss will be at $61, which will be trailed higher as the trade moves in our favor.
Risks to our investment
We have forecast a huge increase in crude oil prices, as we believe that the markets are likely to be in a balance in the first quarter of 2018. However, if the OPEC members fail to extend the production cuts, crude oil prices will again slide back to $40 a barrel levels.
If the geopolitical situation remains calm, we may not get the breakout and rally to $68 levels. Also, if the tax cuts don’t happen or don’t meet street expectations, the stock markets are likely to crash. The Energy sector, being the weakest, will suffer.
Featured image courtesy of Shutterstock.
Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.
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4.7 stars on average, based on 9 rated postsRakesh Upadhyay is a Technical Analyst and Portfolio Consultant for The Summit Group. He has more than a decade of experience as a private trader. His philosophy is to use technical analysis for momentum trading and fundamental analysis for long-term positions. Rakesh likes to keep himself fit by lifting weights and considers himself to be a spiritual person.
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