Five Reasons USO Could Be Ready To Soar

by on May 13, 2010 | ETFs Mentioned:

As worries over a sovereign debt crisis in Europe have rippled throughout the global economy, much of the focus has been on big swings in equity markets as investors flocked to safe havens such as gold and Treasuries. But the chaos of recent weeks has also weighed heavily on commodity markets, as the double whammy of softening demand and a strengthening dollar has sent prices of many natural resources plummeting. Crude oil, which recently seemed to be headed straight towards $100 per barrel, has pulled back sharply over the last week to less than $80.

This time of year, investors are used to gas prices skyrocketing as the summer driving season approaches. But this year is a completely different story, with analysts anticipating that an abundance of supplies will translate into declining prices at the pump. After gas peaked at $4.11 in 2008 and $2.70 last year, many expect prices during the summer months of 2010 to come in well below those levels.

With high inventories and weak global demand, the consensus view on crude oil prices has suddenly turned bearish, sending many funds in the Oil & Gas ETFdb Category down sharply. The largest of these is the United States Oil Fund (USO), which has lost more than 11% since the beginning of the month. For contrarian investors, the recent struggles of USO make it an interesting option. Below, we lay out five reasons why USO could be due for a comeback in coming sessions (see this Guide To Crude Oil ETF Investing):

1. Strong Chinese Demand

The Organization of Petroleum Exporting Countries (OPEC), whose members account for about 40% of global crude oil output, recently said that it expects global oil demand to grow faster than previously expected in 2010. In its monthly report, the cartel said it expects consumption this year to grow by about 950,000 barrels per day, 50,000 barrels a day higher than the forecast from last month’s report.

OPEC cited strong demand in China as the major driver of the upward revision. Strong GDP growth in the world’s largest emerging market pushed demand up 800,000 barrels a day in March compared to a year earlier. If China’s economy keeps up its impressive expansion, oil demand should hold firm.

2. It’s Not Just China

While China’s economic expansion usually dominates the headlines, the growth rates being recorded in several other Asian markets are equally  impressive. It is expected that Malaysia’s economy grew the most since 2000 in the first quarter, as industrial production has strengthened and overseas demand has soared. Last month Singapore reported that GDP grew by more than 30% in the first quarter in annualized terms, a mind-boggling rate that highlighted the gap between the world’s emerging and developed economies.

With Brazil and India also expanding rapidly, the current environment is one of significant growth for emerging markets. In order to fuel this growth, these markets have an insatiable thirst for raw materials, including oil. As developed market demand remains dormant, developing countries seem ready to pick up the slack.

3. More Than Just Fuel

To most consumers, oil is viewed as a source of energy needed to power everyday life. But more and more investors are beginning to look at crude in a new light: as an investable asset. “The oil bulls argue that oil isn’t just fuel, but an alternative asset and a hedge against a further weakening in the dollar,” writes Joseph Lazzaro. “They therefore believe that the power of their viewpoint will prevail over supply-and-demand factors when it comes to oil’s price.”

Although recent weakness in the euro zone has given the dollar a boost, many investors still have concerns about the long-term fate of the greenback, and even more remain concerned about the impact of an uptick in inflation (see Beyond TIP: Ten ETFs To Protect Against Inflation). Since oil is a popular hedge in more ways than one, it isn’t being bought simply for use in automobiles any more. This “investment status” can increase volatility as speculators jump in, but it also increases the universe of potential buyers (most people reading this are likely at least considering an investment in oil).

4. EIA’s Bullish View

The Energy Information Administration doesn’t seem to think that the recent dip in oil prices is here to stay, forecasting that crude oil prices will rise sharply over the next 18 months. “Expectation of a somewhat more robust global economic recovery supports the updated price forecast, particularly if the Organization of the Petroleum Exporting Countries (OPEC) continues to remain satisfied with its supply targets as global oil consumption continues to grow,” says the latest report.

The EIA expects crude prices to be around $87 per barrel in the fourth quarter of 2011, an increase of more than 10% from current levels. And that increase isn’t expected to occur gradually; the organization expects oil to average about $84 per barrel during the second half of 2010 (also see Five ETFs To Hedge Against Skyrocketing Gas Prices).

5. Supply Disruptions Are Never Far Off

In addition to traditional supply and demand factors, an analysis of oil prices also requires consideration of certain geopolitical risks. It’s not uncommon for heightened tensions in oil-rich regions (many of which also generally happen to be politically unstable) to impact prices, as supply disruptions can send a shock through markets. Recent months have been marked by a lack of unexpected supply shocks. It’s been quite the opposite, actually, as demand disruptions have had an adverse impact on prices; the air travel freezes resulting from the volcanic eruption in Iceland sapped demand for jet fuel for several days last month.

It’s obviously difficult to predict a hurricane in the Gulf or a surge of violence in Nigeria. But it’s important to consider the impact that these events can have on oil prices. There’s no guarantee that such an event is coming down the pipeline, but the risk is clearly on the upside. The current situation is about as good as it gets; oil prices aren’t likely to be pushed lower by any unexpected developments. Also make sure to read USO vs. OIL: A Better Crude Oil ETF?

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Disclosure: No positions at time of writing.