(The following is a Guest post on MarketFolly.com. 'Tradefast' is the nickname of an independent equity trader who has more than 20 years of market experience at a major financial institution and two hedge funds. He now trades for a private investment fund, using a combination of both fundamentals and technicals. (That sounds like our kinda guy!) You can follow Tradefast on Twitter, and catch his thoughts on his blog.)
Market Folly: 'Tradefast' sat down to explain how contango affects the crude oil ETFs and ETNs many investors and traders usually play, including US Oil Fund ETF (NYSEARCA:USO), iPath S&P Crude Oil Total Return Index (OIL), and the PowerShares DB Oil Fund (NYSEARCA:DBO).
The US Oil Fund holds long positions in West Texas Intermediate crude oil futures contracts, and rolls these contracts forward each month. Like most futures traders, USO buys futures with leverage, putting up a small portion of the money to buy the contracts. The rest of the money is invested in Treasuries, which generates interest income for the fund.
Three factors play a role in determining the performance of USO: 1) changes in the spot price of crude oil, 2) interest income on un-invested cash, and 3), the 'roll yield'. The first two factors are easily understood, but the third factor, 'roll yield' should be examined further in order to determine the extent, if any, to which traders of USO will be surprised by its performance in relation to spot crude oil.
First, some background: Oil futures are available for each month of the year, so you can buy a futures contract right now which gives you the right to buy oil in February 2009, March 2009, April 2009, and so on. Currently, the price of oil in February 2009 is less than the price of oil in April 2009, a condition that is referred to as 'contango'. (If the opposite were true, the market for crude oil would be in backwardation.) Most commodity funds, including the US Oil Fund buy what is called the 'near month' contract and, because they do not want to take physical delivery of the commodity, they sell the current month's contract before it expires and buy into next month's contract. This process is called 'rolling forward', and it can result in the ETF paying up if the forward month contract is higher than the current month (contango), or cashing out if the opposition condition exists (backwardation).
To investigate the issue, I read through the 'risk factors' section of the USO prospectus. The following is relevant:
In the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result, the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.
In essence, the USO prospectus is warning traders that USO may experience a negative 'roll yield' that may cause the NAV of USO to deviate significantly from the spot price of crude. Is there historical precedence for USO deviating from spot oil by a material amount? As it turns out, the answer is 'yes.'
During the past two years, including 2006, these markets have experienced contango. This has impacted the total return on an investment in USOF units during the past year, relative to a hypothetical direct investment in crude oil. For example an investment made in USOF units on April 10 and held to December 31, 2006 decreased, based upon the changes in the closing market prices for USOF units on those days, by 23.03%, while the spot price of crude oil for immediate delivery during the same period decreased 11.18%.
The conclusion, at this stage of analysis, is that USO is not a direct play on the spot price of crude oil - it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (the slop of the futures curve).
For a trader who is long USO, my instinct is that maintenance or aggravation of the contango in crude oil will cause impairment of the value of USO in relation to spot crude - whereas, any mitigation of the contango situation (including a shift to a flatter curve or backwardation) will enhance the performance of USO.
I plan to study this issue more extensively. But, in the mean time, I will not consider USO to be a good proxy for the spot price of crude oil - and I will be particularly leery of participating in USO for anything other than a short-term trade.
Market Folly: 'Tradefast' highlights an issue that many have overlooked or just not taken the time to research. Many perceive that USO is the "best way to play oil" since it's the front-month contract. But, as he points out, depending on how crude oil is trading in the front month and beyond, there are some issues with this ETF. So, as always, read the prospectus of each fund you're trading or investing in as it's important to understand exactly what it is you're dealing with.
In the comments section of his original article, he goes on to address similar issues in other crude oil ETF's and ETN's. Regarding ticker OIL, he writes:
Here is a link to the prospectus for OIL, the IPath crude Oil ETN.
The 'contango issue' is discussed on PS-10. Short answer: yes, a contango market in crude oil will result in negative roll yields - similar to USO.
Also, be aware that OIL is an ETN (exchange traded note), rather than an ETF (exchange traded fund). With ETNs, you are an unsecured creditor of Barclays (the issuer of the note), so you have credit risk overlaid on the risk of the commodity.
In a former life, I used to enter into total return swaps on various indices with Lehman as the counterparty. I halted this practice long before LEH became a troubled credit. My sense is that the popularity of ETNs have fallen in relation to ETFs, because of the credit risk.
I have no strong opinions regarding Barclay's default risk, but it might be worthwhile to consider that Barclays CDS widened by a meaningful 98 bps on Friday, and the stock declined 24%. Although the current CDS spread of 265 bps is not indicative of extremely high default risk, the level and direction are cause for some concern. (Barclays credit risk can be hedged with CDS, but this is a market for institutional investors - and shorting Barclays stock against a long position in OIL exposes the OIL holder to unacceptable basis risk. Ergo, I would prefer ETFs (such as USO) over this specific ETN (NYSEARCA:OIL).
Market Folly: He also addresses the Powershares ETF: DBO, writing:
I took a quick glance at DBO from PowerShares. In the prospectus, PowerShares notes the following:
Rather than select a new futures contract based on a predetermined schedule (e.g., monthly), each Index Commodity rolls to the futures contract which generates the best possible ‘implied roll yield.’ The futures contract with a delivery month within the next thirteen months which generates the best possible implied roll yield will be included in each Index. As a result, each Index Commodity is able to potentially maximize the roll benefits in backwardated markets and minimize the losses from rolling in contangoed markets.
My interpretation of this statement is that the manager of the ETF utilizes a certain amount of discretion with respect to the futures roll. If the forward curve were humped (i.e. backwarded to some point, and contango thereafter), a skillful manager might be able to take advantage. I do not claim expertise in this area, but my observation is that the current market in Crude Oil is in contango as far as the eye can see, and there does not appear to be any immediate advantage to having a selection of forward contracts with which to complete the roll. Also, keep in mind that with active management there are potential advantages (the manager may make a skillful maneuver) and potential risks (the manager may screw up and underperform the benchmark).
Currently, I am not commenting on the leverage associated with DBO, it is beyond the scope of this particular topic (contango effects on crude oil ETFs and ETNs).
Market Folly: This is some real insight from 'Tradefast.' We definitely appreciate his effort to research and write about each of the various popular ways to play crude oil in equity markets. We feel this is an important topic that needed to be addressed, seeing how so many people trade or invest in these ETFs/ETNs without even blinking an eye. So, thanks again to 'Tradefast' for the guest post.
For some of our coverage of crude oil, check out the recent slide presentation: Cheap Oil = Over. Additionally, we've commented on cheap oil ourselves, and have covered energy trader Eric Bolling's latest oil trades and thoughts.