The bankruptcy of Silicon Valley Bank (SIVB) and Credit Suisse (CS) crisis jolted both the financial and oil markets with investors fearing a recession, synonymous with lower demand and prices.
Thus, amid concerns over the potential economic impact, both crude and natural gas prices reached a trough on Wednesday. While WTI (West Texas Intermediate) traded at its lowest level since December 2021, natural gas was relatively less impacted, as its price was slightly above its February lows.
In these circumstances, there can be trading opportunities as prices have room to recoup losses. Thus, the aim of this thesis is to elaborate on such an opportunity by using two ETFs, the Direxion Daily S&P Oil & Gas Exp. & Prod. Bull (NYSEARCA:GUSH) and the ProShares Ultra Bloomberg Natural Gas (NYSEARCA:BOIL) whose shares have both suffered in the last month as shown in the charts below.
Also, given that these two ETFs also make use of leverage, this thesis will also elaborate on the related risks, and I start by enumerating the price action that is also impacting Brent oil which is used by OPEC+ to issue directives about whether to cut production in order to boost prices.
The Price Action
At the time of writing, the barrel of Brent, or North Sea crude oil for delivery in May fell to $72.26, evolving at its lowest level of the year before recovering to $74.47. The price action is broad, with the WTI, also known as Texas Light Sweet, for April delivery, falling to $66.21, a level not seen in 15 months. It has now recovered to above $68. As for natural gas, it has been less impacted by the turmoil grappling the financial industry, but, nonetheless, prices also fell to their lowest level of $2.177 per million BTU or British thermal units earlier in February, a level not seen since Aug 2020.
Talking crude oil prices, one of the catalysts which have led to such lows is faults appearing in the liquidity front after the failure of SVB. This liquidity problem implies deteriorating economic conditions resulting in Goldman Sachs increasing the probability of a U.S. recession to 35% based on banking stress.
This largely explains why crude oil prices plunged, which was also exacerbated by what started as a regional banking crisis in the United States suddenly turning into a European crisis, namely with Credit Suisse (CS) whose largest shareholder ruling out any increase in bank capital causing panic in the market. However, things have now calmed given that the Swiss National Bank has provided a $53.7 billion backstop.
Therefore, with contagion risk having been averted, there should normally be a pickup in the price of crude oil, which should bolster the value of GUSH.
GUSH tracks the S&P Oil & Gas Exploration & Production Select Industry Index (SPSIOPTR) which includes U.S-based companies from the O&G (oil and gas) exploration and production sub-industry, at 73.11% of its overall weight as pictured below. Oil and Gas Refining and Marketing constitute 20.45% of overall weightings, with integrated O&G making up the remaining 6.45%.
With its predominant exposure to production activities, GUSH’s holdings are particularly susceptible to fluctuations in the price of crude oil. Thus, according to my calculation, an approximate 10% change in the price of WTI can trigger a 24% variation in GUSH’s share price which makes it particularly attractive for trading purposes. Therefore, with WTI having retrenched by over $7 in the past week, you can expect a $16.8 (7 x 2.4) gain in GUSH which would put its share price at $126.47.
Looking across the industry, GUSH tracks a modified equal-weighted index designed to measure the performance of sub-industries as pictured above whereas the ProShares Ultra Bloomberg Crude Oil ETF (UCO) which is another 2x bullish ETF tracks WTI Crude Oil futures contracts. As per the chart below, investors will notice that over a period of one year, GUSH has been less volatile than UCO, with the main reason being that the Direxion ETF provides indirect exposure to crude oil, namely through stocks, whereas it is more direct exposure for the ProShares ETF.
This is a noteworthy point for those who are more risk-averse and do not want to trade futures contracts directly. I now move on to BOIL, which, contrary to GUSH, but, in the same way as UCO, tracks an index composed of futures contracts, in this case, natural gas.
BOIL provides investment results on a daily basis, corresponding to 2x the daily performance of the Bloomberg Natural Gas Subindex. This is also a highly leveraged trading instrument that seeks a return equivalent to two times its underlying benchmark. Also, while the ETF’s moves are certainly dictated by the price of natural gas, the fund managers, or ProShares, stress that BOIL is not intended to track the performance of the commodity spot price.
Coming to the price action, the key factor which determines BOIL’s stock trajectory is demand/supply. In this respect, contrary to GUSH, which has recently been more guided by the financial turmoil I mentioned earlier, BOIL is benefiting from the global demand for North American natural gas, as Europe has to offset the shortage due to the cutting off of pipeline supplies from Russia. This in a way constitutes a floor for the price of natural gas and is the reason why despite the EIA (Energy Information Administration), reporting higher gas storage (by 521 Bcf) as of March 10, compared to the same period last year, prices have not come down.
Looking at momentum factors, at an RSI of 38.42, and a share price of $5.05, BOIL could rise further and reach $7.86, a level last reached on March 3, signifying a 56% upside. Moreover, there is a peak observed in the number of U.S. rigs, or the infrastructure needed to collect natural gas, implying that the growth in gas production could be slower than anticipated this year.
However, higher prices can see the less profitable rigs coming back to activity, which means more supply, which could pressure prices. Also, natural gas does not benefit from the same SVB-type momentum as crude oil, and, with the Spring season kicking in, demand for heating gas should diminish. These are the reasons I am not bullish on BOIL at present.
Looking at the longer term, given the current turmoil in the financial market, some companies may prioritize shoring up their balance sheets as recession talks become louder. They could also delay multibillion-dollar investments in longer-term projects which may lead to higher prices, but only by the end of this year.
Volatility and Risks when using Leverage
With so many variables currently at play, including economic slowdown, the war in Eastern Europe, and escalating geopolitical tension between the U.S. and China, volatility should reign in the energy markets. On top, just like the 50 basis point hike by the ECB temporarily initially caused jitters in global stock markets which also extended to energy prices, the degree to which the Federal Reserve will increment interest rates at its next monetary policy meeting on March 22 may prove to be a determining factor as to the way energy prices evolve in the short term. The reason is simply that by actioning the levers of liquidity, the U.S. central bank can determine the path of the U.S. economy, notably, its growth rate which in turn impacts demand for commodities including oil and gas.
Another key stakeholder in the demand-supply equation is OPEC+, the oil cartel which seems to be patiently waiting as it has not issued any directive to its members to reduce production despite Brent falling below $80. This could be because the organization sees strong demand from Asian countries, notably China and India being sustained despite uncertainties in the western world. Thus, a further failure of OPEC+ to act can herald more pain for bullish positions on energy.
In addition, when using BOIL and GUSH ETFs to magnify your gains, there are other risks as highlighted by Seeking Alpha in their “Leveraged ETF coverage policy” section, due to their return dynamics being different from the passive and active funds investors are used to.
Secondly, the fund managers for both funds advise calculating gains on a daily basis (for a single day), due to the compounding effect, In this case, returns can be significantly impacted due to the ETF’s share price fluctuating widely during the trading period. Thus, ProShares advises holding the ETF for the shortest period possible as “holding periods of greater than one day can result in returns that are significantly different than the target return”. Direxion even goes to the extent of stating that “there is no guarantee the funds will meet their stated investment objectives”.
In these circumstances, sticking to the Securities and Exchange Commission’s guidelines, in order to minimize possible losses, the best strategy is to avoid buying-and-holding and, instead, place your bet at a favorable moment as part of a stock trading approach, and be ready to exit in case losses have exceeded what you can endure.
This thesis has shown that, after the banking sector turmoil, the moment could be ripe to trade GUSH as oil recoups back some of its losses. Adding to WTI’s earlier woes, there was also options trading whereby traders limiting exposure in the bearish market sold off crude future contracts in order to hedge their losses. Consequently, as the U.S. government backstops the banking system, there should be more demand for futures contracts, which bodes well for oil.
On the other hand, natural gas has been less impacted by this week’s events and should not benefit from momentum factors. While its RSI remains on the low end, there are not enough ingredients to anticipate an upside for BOIL at this moment, especially when prices are likely to be pressured by weaker seasonal demand.