The Hidden Leverage of Oil ETFs

Financial innovation drives markets. Over the years, we have seen investments that had been the sole province of professionals adapted for retail investors. Among the more popular have been inverse ETFs and commodity-based ETFs.

These new tools may be welcome, but we must watch for unintended consequences. In a previous Seeking Alpha article, I discussed the difficulties of using inverse ETFS as a long-term investment. This past weekend I read an in-depth piece on the oil ETFs and began examining their uses. As with most financial innovations, a grasp of the details is needed to make sure gains do not turn to losses.

I have used the U.S. Oil Fund (USO) as a way to speculate on the price of oil in my weekly newsletter EPIC Insights. Most would expect USO's performance to mirror that of oil. Although the direction of the two is similar, changes in the term structure of oil also impact USO's performance.

Understanding the nature of the futures market is essential to properly utilizing USO. As with other commodities, oil trades for delivery at many different dates. If the price of oil today is higher than the price one month from now, the markets are in backwardation. If the opposite occurs and oil is more expensive in future months, the markets are in contango.

Since USO purchases futures contracts at various points along the curve, the term structure has a material effect on performance. Consider a market where the current-month future contract is $30 and the one-month forward contract is $27. As the current-month contract approaches expiration, USO will sell it for $30 and purchase the next month for $27. Doing so earns a positive roll of $3 and increases performance. This would cause USO to outperform when the market is in backwardation and lag when the market is in contango.

To test this theory, I examined the relative performance of USO and spot oil over various time periods. The results are as follows:

	1/1/07-6/30/07	7/1/07-12/31/07	1/1/08-6/30/08	7/1/08- 12/31/08
Oil Return	15.8%	35.8%	45.8%	-68.1%
USO Return	2.7%	42.9%	50.0%	-70.9%
USO H/(L)	-13.1%	7.1%	4.2%	-2.8%
Market	Contango	Backwardation	Backwardation	Contango

The relative performance of USO in various term-structure environments is essential to understand. Generally, markets in backwardation are bullish, while those in contango are bearish. Knowing that a shift in term structure affects performance, investors buying and selling USO are not only expressing their view of the direction of the markets, but the term structure as well. This nuance serves as a source of leverage that will allow you to maximize gains in losses.

If you are bullish on oil, today's market is ideal. If oil rallys, we should see the substantial contango switch to backwardation and deliver strong performance to those owning USO. If you believe the contango will continue to widen as oil prices decline, a short position will offer extra return. This nuance is key to using USO as an effective portfolio tool. Innovation opens this market to the masses, but we must remain informed to ensure that we are using the products correctly.

Comments

[Kup:]

If you think oil will flounder in a trading range and think that contango will persist, a short position on USO would be appropriate then?

Feb 04 12:27 PM

[ROLEX18:]

USO is the only real ETF that follows spot CL price and trades only in front month futures, I found out that DXO for example, even if in it's prospectus Deutsche Bank writes that DXO is double long Oil, in reality it is not.
DXO trades ( exactly trades, not buys ) not only front Crude Oil futures but even 12 months in advance, that's why it have little to do with what it says it is. But regulators are too busy with Madoff and other fraund going on, I predict that ETF's and ETN's will be the next target of regulators, at least I hope so. Everybody familiar with basics of math and derivatives trading, can show you many irregularities in ETF and ETN universe that include:
1.Disinformation ( Investors are not getting what they are promised to get in the prospectus ).
2.Wrong prices like bid/ask, where most ETF and ETN managers after deriving THEIR price from the OTC or futures exchanges, pass this price to ETF and ETN investors that is not based on the real time orders execution, but have very high premium attached to it. For example if they buy/sell Crude Oil on NYMEX at the average of 41$ you will pay for the same order book at least 41.20$ even if the price on NYMEX for all other futures trader is 41$.
With less liquid ETF and ETN that follow commodities like industrial metals, softs,grains,PGM it is even worse.
The price you get is 10% difference between the bid/ask at the time you buy/sell ETN or ETF and the price managers of ETF or ETN paid at the same time.
3.ETF and ETN in many cases act as proprietery trading desks that employ the market neutral and arbitrage strategy with bias long or short, it means that the small losses that are made by their traders are being passed to you in terms of commissions during the trading day like bid/ask when you trade and bid/ask from what they got wrong.
ETF and ETN are a scam that will be discovered, trade only in ETF's as ETN's are a real scam and stealing of your money.
Trade only in most liquid ETF's in category you are looking at.

Feb 04 01:01 PM

[ROLEX18:]

USO is the only real ETF that follows spot CL price and trades only in front month futures, I found out that DXO for example, even if in it's prospectus Deutsche Bank writes that DXO is double long Oil, in reality it is not.
DXO trades ( exactly trades, not buys ) not only front Crude Oil futures but even 12 months in advance, that's why it have little to do with what it says it is. But regulators are too busy with Madoff and other fraund going on, I predict that ETF's and ETN's will be the next target of regulators, at least I hope so. Everybody familiar with basics of math and derivatives trading, can show you many irregularities in ETF and ETN universe that include:
1.Disinformation ( Investors are not getting what they are promised to get in the prospectus ).
2.Wrong prices like bid/ask, where most ETF and ETN managers after deriving THEIR price from the OTC or futures exchanges, pass this price to ETF and ETN investors that is not based on the real time orders execution, but have very high premium attached to it. For example if they buy/sell Crude Oil on NYMEX at the average of 41$ you will pay for the same order book at least 41.20$ even if the price on NYMEX for all other futures trader is 41$.
With less liquid ETF and ETN that follow commodities like industrial metals, softs,grains,PGM it is even worse.
The price you get is 10% difference between the bid/ask at the time you buy/sell ETN or ETF and the price managers of ETF or ETN paid at the same time.
3.ETF and ETN in many cases act as proprietery trading desks that employ the market neutral and arbitrage strategy with bias long or short, it means that the small losses that are made by their traders are being passed to you in terms of commissions during the trading day like bid/ask when you trade and bid/ask from what they got wrong.
ETF and ETN are a scam that will be discovered, trade only in ETF's as ETN's are a real scam and stealing of your money.
Trade only in most liquid ETF's in category you are looking at.

Feb 04 01:02 PM

[AMF:]

Interesting and detailed analysis but it does not solve the problem of investing when crude oil is in contango (or super contango as it was 2-3 weeks ago). Have you looked or consider other alternatives such USL or UOY? USL was devised to mitigate the ravages of contango, or negative roll yield, on crude oil futures returns (USL's price is based upon the average of the nearest 12 delivery months of NYMEX crude oil futures). UOY, which represents an economic interest in ¼ of barrel, was created as symmetrical pair with DOY (short) derives its value form each other and doesn't own futures contracts, it does use the front month contract to set the reference price for determining the NAV.

Thx

AMF

Feb 04 03:14 PM

[Child Psych...:]

Sean:

Although I think the effect of contango vs. backwardation on USO is pretty well known on these pages, it was helpful to see an analysis comparing the returns of USO vs. WTIC in different periods of varying structure. You might also mention that USO rolls over the contracts on one day per month, and that day happens to be this Friday. One would think that the inevitable haircut that USO will take when it rolls March into April would somehow already be baked into today's price; if it wasn't, this would seem an obvious shorting opportunity. But in a market this liquid, it seems unlikely that such easy opportunities exist.

Feb 04 04:40 PM

[dogsofmyhead:]

Thoughtful comment AMF, thanks. I've been using USO, DXO and ERX despite their faults, I'm going to look into your alts.

Feb 04 11:14 PM

[dogsofmyhead:]

Aha, UOY, DOY and USL are too thinly traded, I look for about 1m average volume to avoid huge bid/ask spreads.

Feb 04 11:17 PM