The 2026 Iran War has caused a rare, high correlation between USO and SPY, making oil risk the dominant driver of the entire market.

Despite rising oil prices, investors are aggressively shorting USO to play a "mean reversion" strategy, betting on an eventual resolution rather than a short squeeze.

Energy stocks (XLE/XOM) are falling due to war-related costs and windfall taxes, with short interest decreasing as investors take profits on the decline.

USO and SPY are usually not strongly correlated, as the S&P 500 is influenced by a wide array of macro factors. Recently, the correlation is very high, showing that the 2026 Iran war/oil risk is the dominant factor accounting for most of the S&P's returns. This is a rare situation and only happens during a systemic macro event.

When we examine USO’s short selling sentiment data, we find a pattern of increasing shorting on the way up, also known as range trading and reversal. This means that USO equity investors are basically playing for a reversion, positioning for the view that the oil situation will at some point be resolved.

This is the opposite of a panic or a typical short squeeze.

The combination of rising returns and rising short positions does cause a high short squeeze risk, but the structural model for ETFs is different than that for stocks. While the Short interest % of float can be as high as 70%, this is a byproduct of the same shares being repeatedly loaned and borrowed.

At the same time, the Energy Sector ETF (XLE) is going down—comprising prominent companies like XOM and CVX. While energy prices are high, many companies are losing money due to the physical destruction of infrastructure, skyrocketing insurance costs, and supply blockades in the Strait of Hormuz.

Additionally, aggressive government price caps and "windfall taxes" are capturing potential profits to shield consumers from the economic fallout of the 2026 Iran War.

In these names, short interest has been going down. This represents a momentum situation with investors covering shorts to take profits on the way down. We see the same pattern in XOM of declining shorts and falling stock prices. Investors are covering (buying back shares) on the way down in a systematic reversal strategy.

Effectively, investors are shorting USO on the way up and buying XLE and XOM on the way down. The net trade is Short Oil / Long Energy Equities.

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