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2019-11-09 21:29:50

Over the last month, we’ve seen the Credit Suisse Crude Oil Shares Covered Call ETN (USOI) experience a slight decline in value while other oil ETPs have seen gains. In this article, I will dig into exactly what is driving returns for USOI at this moment and explain why I believe that it is a good investment at this time for some investors.

Understanding USOI

If you’ve found your way to an article about USOI, there’s a good chance that you understand the backstory for the instrument and what exactly it’s trying to accomplish. If so, feel free to skip down to the section on crude fundamentals and why I believe crude will rise in the future. But if you’re looking to brush up on exactly what USOI is, this section is for you.

In the past when I’ve described what USOI does, I’ve used a simple phrase to capture the essence of the ETN: if you understand USO, you understand USOI. The reason why I say this is pretty simple – USOI is an ETN which gives the returns of holding the USO ETF and selling a covered call against the position that is 6% out of the money and paying that value out as a dividend. That’s it – it’s fairly simple. But there is a lot of nuance behind the ETN.

Let’s start with the covered call piece. For this piece of the strategy, USOI will intentionally cap its upside through selling calls on USO 6% above the market on a monthly basis. This tangibly means that if crude market rally by over 6%, investors will not share in these returns. This strategy works great when the market is falling (and you’re determined to hold oil exposure) and when the market is trading sideways. However, when the market trends upwards, you will tend to lag the market holding USOI because you’ve sold off your upside in favor of dividends. To understand the impacts purely on the price piece, here is a comparison of the last 5 years of returns of USO and USOI.

As you can see, USOI only really started trading in mid-2017 and since then, it has underperformed USO by about 34% on a purely price basis. However, when you factor in the dividends piece, USOI has delivered around 12% per year in dividends. Depending on if you reinvest your dividends, this still generally means that USOI lags USO – but keep in mind this is dependent upon the actual price trends in crude oil and is not consistent for every month or quarter.

The second piece to understand about USOI is roll yield. Put simply, roll yield is the gain or loss that arises from holding exposure across the forward curve. When USO (and USOI) roll exposure, they do so by selling out of the front month contract and buying into the second month futures contract at about two weeks before expiry of the front month. At present, USO is in the middle of its rolling process which means that exposure is moving from December to January futures.

This means that the returns shares see will not only be a component of price movements in crude oil but also the effects of roll yield which is the tendency for the second month futures contract to approach the front month as time progresses.

This relationship is not ironclad and there certainly are excursions from it, but over time, these effects can cause a serious impact on shares. For example, over the last decade, the front two months of WTI have been in contango for about 80% of all months. This means that roll yield has been negative for USO over this time period. To see the impact of this negative roll, here is the comparison of the return of WTI and USO over the last decade.

As you can see, the impacts of rolling exposure in a contango market are real and material. In some years, USO underperformed the price moves in WTI by dozens of percentage points. This is a real effect and is important to keep in mind if you are holding USOI since it’s just USO with a covered call strategy.

So in summary about USOI – it’s a good product if you’re willing to sell off your upside in exchange for dividends. For example, USO has rallied by 10% over the last month, but USOI has fallen by 2% (while paying a dividend that’s annualizing at around 12%). Also, USOI is exposed to roll yield which means that investors need to monitor the shape of the forward curve to determine if they are comfortable with the level of contango in the market.

Crude Markets

In this piece, I’ve primarily focused on the nuance contained in the USOI ETN because there’s a good chance that if you’re looking for information on something so specialized as this ETN, you already have a market view on crude oil. However, if this is not the case, here’s my take on crude markets. In this piece, I don’t have the space to do a full analysis of crude fundamentals, but if you’d like to read my latest deep-dive, it is here.

The underlying story for crude oil is this: inventories have been weakening against benchmarks like the 5-year average and 2018’s levels.

This weakness in stocks is broad-based across the United States with most PADDs seeing inventories either at the 5-year average or under it. This indicates that crude inventories are drawing down and is a statement that supply is unable to keep up with demand.

Even though demand has been weak this year…

…we have seen production growth slow:

…and imports collapse:

The two main drivers here are bankruptcies in the Permian which are slowing operations and OPEC cuts which were extended through March of 2020. OPEC meets again in December and I currently believe that we will see an extension of the cuts which are in place. These cuts have effectively removed nearly 500 million barrels from the United States this year as compared to the 5-year average of imports.

As long as we continue to see weakness on the supply side of the balance, we are going to see inventories continue to falter and drawdown. It is my belief that within a year, the current trajectory will carry us into outright draws in crude inventories which will result in higher prices of crude oil. It is a great day to be long crude oil to capture the coming rally.

Conclusion

USOI provides a way for investors to participate in the oil trade and earn dividends in exchange for upside in shares. USOI is exposed to the same set of roll factors which impact USO, so monitoring the forward curve is important for timing holdings. The supply side of the balance is seeing serious risk which is likely to propel the price of crude higher.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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