UCO: The Middle East Tensions May Drive Bullish Momentum For Oil

A terrorist attack by Hamas on Israel on October 7th has launched a chain of events that’s begun to transform the Middle East. Even though oil has been moving up hesitantly in the past three weeks, for me, it’s becoming increasingly more clear that oil prices may get a powerful boost amid rising escalation in the Middle East.

In this regard, the ProShares Ultra Bloomberg Crude Oil ETF (NYSEARCA:UCO) may be considered a decent speculative option to exploit a short-term bullish momentum in the oil market.

Further Escalation Looks Imminent

To keep focus, I’ll discuss only the most recent events after the October 7th attack. In the last three weeks, Israel had been preparing for a land operation in the Gaza Strip, where Hamas has been ruling for the past 15 years.

The continuous delay of the land operation, coupled with diplomatic efforts to rescue hostages, has soothed markets and made investors think that further escalation is unlikely.

Nonetheless, in the last days of October the Israeli Defense Forces (the IDF) have slowly but steadily entered the Gaza Strip territory. It’s not a lightning-fast massive incursion the markets might have expect when IDF initially announced the land operation, though it ultimately means that there’s a path of further escalation of the conflict.

For Israel, there’s basically no option to continue containing Hamas within Gaza without a land intervention in my view. I believe Israel’s multi-year policy of Hamas “appeasement” through increasing economic cooperation between Gaza and Israel has proved to be ineffective as we can see from Oct. 7 events.

The key risk for Israel is that Iran and its proxies might take the opportunity and potentially strike Israel from the North, while Arab countries around Israel may fuel anti-Israel sentiment in the West Bank if a land operation in Gaza results in numerous civilian casualties.

If Iran joins the conflict either directly or indirectly, that would almost inevitably mean the US will have to use force to protect Israel. Involvement of the US and Iran may turn the initially limited Israel-Hamas conflict into a broader Middle East confrontation.

WTI May Return To $90, But Beware Demand Destruction

In the past few weeks, oil demonstrated mixed performance, being unable to surpass a local high of $93 per barrel reached in late September.

My view is that the situation in the oil market is about to change radically soon. For reference, the Middle East region accounts for almost a third of all oil production.

One of the main opponents of Israel in the region, Iran, produces around 3 million barrels of oil per day. As we can see from the chart below, Iran has managed to improve oil production by roughly 500 kbpd in a span of a year, supposedly because of the US being less effective in enforcing sanctions amid agreement talks between Iran and the US this year.

If we assume that strict enforcement of sanctions gradually reverses Iran’s production gains, that would eventually exclude at least 400-500 kpbd of oil from the market. I’d say this is the mildest consequence that may occur for the oil market in case of a larger conflict. A way more significant threat is that in case of a broader conflict Iran may disrupt oil supplies coming through the Strait of Hormuz, the key trade route for Middle East oil producers.

However, a perspective of skyrocketing oil prices may be not a particularly attractive one for oil bulls in the longer term. According to Bloomberg, gasoline demand in the US plunged in early October amid even not-extremely-high oil prices ranging between $80 and $90 per barrel.

High interest rates across the globe will inevitably continue to pull down economic activity, limiting the global capacity to sustain higher oil prices in the medium term. For example, in its September report, the OECD already expects weaker GDP growth in 2024 compared to 2023.

Any continuous conflict in the Middle East with oil prices going up much higher will likely result in further suppression of the world’s economic activity combined with demand destruction, rather than a sustainable status quo where oil producers steadily mint loads of cash like they currently do.

Exploiting A Tactical Opportunity Through UCO

ProShares Ultra Bloomberg Crude Oil ETF is a high-risk investment vehicle, which provides a leveraged exposure to the oil market. This ETF seeks a 2x return of its underlying benchmark (Bloomberg Commodity Balanced WTI Crude Oil Index) for a single day, thus it should be used for short-term trades only. In a detailed breakdown of leveraged and inversed ETFs, the U.S. Securities and Exchange Commission (SEC) emphasizes risks for buy-and-hold investors. In short, the performance of leveraged ETFs may significantly differ over longer periods of time because the majority of leveraged funds rebalance at the market close each day. Daily rebalancing (which is applied to UCO as well) means the price movements are calculated on a percentage basis for that day and that day only. Over the longer term, this results in multi-day tracking inefficiency also called the “beta slippage“.

As we can see from the holdings structure, UCO basically represents a mix of derivatives (swaps and futures), designed in a way to follow the benchmark as closely as possible.

Therefore, ETFs like UCO serve as a “plug and play” alternative to the manual picking of derivatives to get leveraged exposure to oil. Again, the 2x leverage means that your gains or losses will double depending on how the WTI oil price performs.

After the October 7 attack on Israel, oil performance is closely linked to the news flow from the Middle East, which is supported by extensive news coverage of the conflict.

In a geopolitically-driven oil market, I don’t find it productive to apply technical analysis because geopolitics is all about specific “trigger events”, that drive markets upwards or downwards. Within this speculative bullish investment idea, I see the following “triggers” for oil:

• The US and/or Iranian proxies (or Iran itself) join the Israel-Hamas conflict.
• The situation around the West Bank destabilizes, leading to direct confrontation of Israel with Palestinian militant groups.
• Military actions of Israel in Gaza take too long, provoking a joint military reaction of Arab countries towards Israel. This particular point may sound wild, though not completely unrealistic in my opinion, therefore I decided to include it as well.

In such an environment, WTI can relatively easily reach $90 once again in the next week or two, implying a more than 5% “unleveraged” upside. With UCO, your gains may potentially be doubled.

Risks To My Bullish Thesis

For sure, there are also risks to my short-term bullish thesis on oil:

1. If Israel somehow manages to rescue all the hostages taken by Hamas without a large-scale land operation, then Israel may decide not to hold such an operation at all, considering international pressure on Israel and almost direct threats from neighboring countries. In such a case, oil prices may sharply decline.
2. The next Federal Open Market Committee meeting will be held on November 1, 2023. While this event is not directly related to the oil market, any hawkish statements from the Fed will negatively affect commodities, including oil, as USD may start strengthening again. Historically, the stronger the dollar, the weaker the commodities.

The Bottom Line

In the short term, I’m surely bullish on oil given what I think are the quite obvious prospects of a large-scale conflict in the Middle East. However, the reversal may come relatively soon in 2024, when lagged effects of high interest rates coincide with uncomfortably high oil prices as a result of the conflict.

The current market evidence shows that every sign of escalation leads to growth in oil prices, thus it’s pretty logical to expect an emotional reaction in the oil market if any of the aforementioned triggers materialize.