Thursday, January 1, 2009

Oil Updated (DXO & DTO)

Since I wrote my last post on oil, NYMEX crude dropped from 43.60/bbl to 35.35/bbl before recovering yesterday to close at 44.60/bbl. USO (crude oil ETF) dropped from about 36 to a low of 27.73 and finally closing yesterday at 33.10 with an intraday high of 34.87. It would seem that I was a bit premature in my statement of a bottom in crude prices forming. However, despite the drop below the Dec. 16th closing I would still maintain that crude is in the process of forming a level bottom.

Anyone that follows ETFs is aware that some funds attract more volume than others and many should just be taken out back and shot to be put out of their misery. Crude oil has several ETFs available in the ultra and ultrashort forms but DXO and DTO from Powershares got a bit of a headstart on their counterparts UCO/SCO from ProShares. By dumb luck, the launch of DXO and DTO almost perfectly coincides with the summer peak of crude oil prices. Let's look at some charts:

Most people I know don't actually trade crude on NYMEX so the next best thing available is USO - the crude oil ETF. The behaviour of USO is a little different than a 1:1 correlation due to the contango/rolling effects that impacts the fund. Anyway, USO peaked on July 11th at 119.17 before closing that day at 117.39. From that price to the close yesterday represents a -71.8% loss in value. It would have been even worse had oil not rallied so much on... geopolitical instability perhaps? (More on that later.) Let's move on to DXO and DTO.

DXO is a double-long ETN and DTO is its double-short companion. (I'll leave it to the reader to research the differences between ETNs vs. ETFs) Both of these began trading on 6/23/08 when USO closed at 110.92. DXO opened that day at 24.50 and DTO opened 25.29. Interestingly, there was a significant volume disparity with DXO trading a paltry 1900 shares to DTO's 525k. Very interesting considering what happens next...

Take a look at the 13 period MAs in the volume graph. (Red lines) During the run up to oil's peak, average volume moves up for DTO and maintains a fairly steady pace through September when the volume begins to taper off to its current low levels. DXO on the other hand is a mirror image. Volume is rather dead until very late November when the MA(13) on volume begins to register a few blips of a pulse and then picks up real vigor into December as crude prices continued to plunge and DXO's price, from a summer high of 29.65 tumbled -94% to a low of 1.76 on Dec. 26th.

I believe that the mirror image volume behaviour represents the crude high and low reasonably well. Further, DXO - particularly if you were wise/lucky enough to pick it up around $2 -represents a low-risk entry point.

A bit of a digression: I am aware that double-long/short ETF suffer from value destruction during volatile markets due to their daily rebalancing required to meet their goals of double daily percentage moves vs their respective benchmarks. However, when markets move in a somewhat linear fashion - as crude did falling from its summer peak - the compounded gains using the levered ETFs can be very rewarding. As evidence of that, USO fell -71.8% from its peak and its prospectus states that it attempts to replicate WTI NYMEX pricing. DXO fell -94%. DTO on the other hand was a true winner from its inception, with an all-time high closing price of 160.30 representing a gain of 533%. Shorting USO or DXO would not have delivered these gains.

So, assuming the traders in these ETFs know what they are doing, this would be a signal that crude is nearly at a bottom.

Briefly revisiting the geopolitical instability comment above and at risk of sounding like one of the tin-foil hat fashionistas, I will say this: the governments of Iran, Russia, Venezuela and various other oil exporting states had strengthened themselves via oil revenues and developed budgets with assumptions of oil at a far higher price than the current $40/bbl area. I do not believe it is a big leap to connect the dots between Iran, Hamas and a risk-premium that seems to attach to crude whenever some instability pops up in the Middle-East. My guess is that we will see more of this type of stuff going on in the next year as various governments in these oil exporting states try to maneuver under the pressure of reduced oil revenues. Some of these maneuvers will serve as attempts to drive up the price of crude. Others will simply be defaults like Ecuador's Correa. Should be a fun year!

USO Chart (Yahoo!)
DXO Chart (Yahoo!)
DTO Chart (Yahoo!)