OILK ETF: Dampened Demand And Expanding Supply

Summary View

I am bearish on K-1 Free Crude Oil Strategy ETF (BATS:OILK), which tracks crude oil futures. I believe upstream supply expansions and lower than expected demand from long-awaited catalysts such as a re-opening of China’s economy will put further pressure on oil prices.

Despite my bearish view, I am not going to short oil futures or bet against OILK. I think that is a riskier proposition as in my experience, betting against securities tends to be a harder endeavor. Instead, I use my bearish oil outlook to help me generate other trade ideas, which I will likely discuss in future articles.

Why I’m Looking at Oil

Much of the world’s economy is driven by natural resources. And oil is still the primary source of energy that powers global economic activity. Some bottom-up investors don’t bother predicting or forming a view on oil prices, and aim to build a portfolio that is balanced across time regardless of oil price outlooks. However, in my investment process, explicit consideration on oil prices, other commodity drivers, currencies and rates are integral to my idea generation process. Hence, I regularly review my outlook on oil prices.

So here is my take on oil prices, viewed via the lens of the K-1 Free Crude Oil Strategy ETF, which tracks the WTI Crude Oil Futures (CL1:COM), in case you want a vehicle to bet on oil futures:

Fundamental Drivers of OILK

Naturally, WTI crude oil demand and supply drive OILK. Underneath this, in the current context, I believe the key themes to focus on are the energy needs of Europe this winter, production and capacity expansion dynamics and the global economic outlook.

It’s a Warm Sunny… Winter?

The war between Russia and Ukraine is raging on with no end in sight. Putin’s plan to restrict critical energy supplies to Europe throughout 2022 and thus force the European continent to bring them back to the negotiation table, may have made strategic sense from Russia’s perspective given Germany’s high dependence (60% of overall sourcing) on Russian gas.

But Mother Nature has blessed Europe with a much warmer winter than expected. For context, the Weather Service in Germany has been recording temperatures of over 20 degrees Celsius or over 68 Fahrenheit. This has not happened since 1881! And this kind of phenomenon is happening all across Europe. As Reuters reported:

Hundreds of sites have seen temperature records smashed in the past days, from Switzerland to Poland to Hungary…

This is reducing Europe’s energy demand as its gas storage buffers still stand high at above 80%. Lower demand than expected for energy puts downward pressure on oil prices and hence the OILK ETF.

BP Expanding US Supply

Recently, BP plc (BP) announced that it plans to expand US O&G production by over 40% in 2023 to $2.4 billion from $1.7 billion last year. This increase in upstream O&G supply is something I have identified as a catalyst for the midstream O&G sector in my article on AMZA (AMZA), a mid-stream O&G ETF. However, this development does not favor oil prices as increased supply eases upward pressures on prices.

Disappointing Demand, Recessionary Outlooks

Some hedge fund managers have made a bullish case for oil to go to over $140/bbl in 2023 on the back of a full reopening of China’s economy. However, this catalyst has disappointed so far. A less than stellar demand impact from China’s re-opening of the economy is also leading to price cuts:

Saudis are slashing prices as the short-term crude demand outlook seems like it won’t quite get a major boost from a robust China reopening…

– Ed Moya, Senior Market Analyst, The Americas, at OANDA

OPEC cutting their forecast for growth in world oil demand for the fourth time since April for next year’s figures citing slowing economies.

More broadly, recession is on everyone’s minds and it is not just in the United States. The World Bank recently warned of a global recession in 2023. Naturally, this would lead to lower production in the economy, lower oil demand and hence prices.

Overall Outlook

As can be seen in the chart above, crude oil futures have printed a peaked in mid-year 2022 at $123.70/bbl. As the fundamental drivers are pointing towards lower demand and higher supply for now, I believe there is further downside for crude oil futures. I would not be surprised by a further drop down towards $65.87/bbl, which would correspond to a fall of a further 11.74%.

Verdict on OILK

Both the supply and demand outlook I have points towards further downside in oil prices. Hence, I am bearish on OILK. From a positioning perspective, I would not like to bet against this security directly. Rather, I am more comfortable using this bearish oil view as a starting point for new idea generation:

Investment Ideas

With increasing supply-side investments, I would turn incrementally positive on mid-stream O&G plays such as AMZA and Energy Transfer (ET).

I would also turn incrementally bullish on oil import nations such as India. I am currently researching some investment ideas here and will share my views on it soon.