Contango Scares USO, DBO Investors

Contango is the deepening discount of near month oil futures contracts against later months. This little monster is scaring investors off simple passive funds such as USO, DBO and OIL which helped drive the big oil rally in the last six years.

Passive index plays like USO and OIL found big profits during much of oil's rally to over 147 a barrel in July by selling front month futures contracts and buying cheaper ahead the curve contracts, something possible only in a market structure called backwardation.

Oil prices have collapsed to 35 dollars a barrel, pushing front month futures contracts into a discount to later months. This is a market showing contango, which forces investors to pay out rather than profit when shifting cash from one month to the next. Now it is extremely expensive to buy and hold oil. The rollovers will just kill you.

The only explanation I have for this deep discount in front month is the government selling oil to stimulate the economy. But that would be too much, wouldn't it?

Disclosure: no positions

Comments

[pseudosavy:]

Are you saying that there are fees associated with rollovers in USO, or are you saying that the rolling forward costs will cause USO prices to drop even as prices stay level and contango exists?

2008 Dec 23 06:55 AM

[DougM:]

I think the latter - you'll lose a few bucks every month even if prices just stay flat, because you'll have negative roll yield. Your money will go straight into the pockets of people doing the storage arbitrage (buying at spot one month while selling you next month's contract at a higher price than it costs to store the oil).

2008 Dec 23 03:14 PM

[John Lounsbury:]

We just saw about a $5 move up in oil associated with the roll-over from expiring December contracts to January. Almost half of that has been given back in the first two days of the new contract. In this situation, the effect on USO could be smoothed out over a few days.

2008 Dec 23 04:46 PM

[John Lounsbury:]

I just checked the five-day chart for USO. It did not reflect the abrupt change in the price of oil with the December to January contract roll-over.

USO fell from a 36 open Wed. 12/17 to a 33 close Fri. 12/19 (expiration day). USO has continued to decline quite smoothly and closed at 30 today (Tues. 12/23).

I am not sure why USO has not fluctuated with the short-term spot price, but I expect it is because it is using a variety of vehicles which can smooth the ETF price fluctuations (daily) while tracking the longer term (several day)changes .

2008 Dec 23 05:34 PM