ETF Investors Mistakenly Stock Up on USO: Buy USL Instead

By Matthew Hougan

Investors are pouring money into the United States Oil Fund (USO) right now. They must be out of their minds.

I have nothing against people wanting to buy oil at $40/barrel. That's a cheap price, and there's reason to believe that spot crude may rise over the next six-to-twelve months. OPEC appears to be sticking by its production cuts, overall supply is down and it feels like the global economy may be leveling off. Oil could easily go to $50/barrel, which would be a 25% jump from here. Where else in today's market are you going to get that kind of return?

But if you want to profit from that rise, USO isn't the way to do it.

This is a big deal. According to the Wall Street Journal, investors poured $3.46 billion in new money into the U.S. Oil Fund in December and January. That makes my hair stand on end, because those investors have gotten crushed. And if things stay the way they are today, they're going to continue to get crushed.

The reason, as I've written about time and time again, is contango. The oil market is in violent contango right now. All else being equal, any strategy that focuses on buying the front-month futures contract and rolling it forward is going to lose money. A lot of money.

This is simple mathematics, and it pains me that people are missing the story.

Here are the current prices for oil contracts with expirations in the next six months. Notice how every contract is more expensive than the one that preceded it. USO follows a simple strategy of buying the current contract and then rolling into the next contract before the current one expires.

March 2009	$40.42
April 2009	$46.22
May 2009	$48.88
June 2009	$50.45
July 2009	$51.28
August 2009	$52.70
Source: NYMEX. Data as of 2/9/08.

Until last Friday, USO owned the March 2009 contract. Specifically, it owned 84,378 March contracts, entitling it to 84.4 million barrels of oil.

But on Friday, it sold all those contracts and bought the April contract instead. But because the April contract cost $6/barrel more than the March contract, it couldn't afford as many contracts. In fact, if you exclude new inflows into the fund, it could only buy 73,444 April contracts.

Whammo presto, the holders of USO lost 13.4% of their exposure to crude oil. They now control less oil. If the spot price stays near $40/barrel, the value of those April contracts will decay back to $40/barrel over the next month and investors will lose their shirts. If the price of oil jumps 15% in the next month—before USO rolls again into the May contract—investors will only break even.

This contango effect killed oil investors in January, according to Standard and Poor's, which runs the most important commodity index in the world.

"The steep contango in the WTI crude oil futures market (when further-out futures trade at a premium) was the primary factor causing the S&P GSCI Crude Oil Index to decline 18.90% in January. The spot price of crude oil dropped 6.55% on the month, but rolling from the February to the March future contacts accounted for most of the remaining 12.35% of the decline in the component index."

Got it? Contango cost you 12% in January. And it's worse now.

What's so horrible about watching people plow their money into an investment that they don't understand is that there are so many nice, viable alternatives out there.

The same company that offers USO offers a great little fund called the U.S. 12-Month Oil Fund (USL). Rather than simply holding the near-month futures contract, USL holds equal positions in each of the next 12 months' worth of futures contracts. Spreading out its bets like that helps minimize contango, which tends to be worse in the near-month contract, and gives you more direct exposure to the spot price of crude.

Not surprisingly, over the past three months, USL has outperformed USO by 13%.

Comments

[Carl Spackler:]

I am buying a mutual fund for this very reason. ICENX is the ICON Energy mutual fund that invests in Oil stocks. It is no load, minimum $1000 investment, low expense ration, and charges only a $49 if you exit the position in the first 90 days. Another good feature - they have less than $400 million under management. Its small and nimble.

Feb 09 05:18 PM

[Ron Finberg:]

Anyone know if the "contango" phenomenum is a current anomoly caused by excess volotilty, or is this the norm. Also, was the inverse occuring when crude was heading higher?

Feb 09 07:18 PM

[User 354208:]

nobody knows if the current term structure will stay the same in the next month, maybe it will change to backwardation..There is no sure bet that USL will outperform USO in the future. If USL in fact were a better or even riskless play to be long crude oil than it could be exploitet through arbitrage and the differece would disappear.

Feb 10 06:24 AM

[nautilus508:]

Anybody know if UNG has the same structure at USO? It appears that the natural gas futures contracts do not have as severe a contango at crude.
March vs June = 3.3%

Feb 10 07:01 AM

[MarketVViz:]

If you think oil is going higher, why not buy a fund of oil sector stocks instead? If oil goes up significantly, the stocks could go up by an even greater percentage.

Feb 10 11:08 AM

[ak1004:]

29.63-29.70 at 11:20.
How is it 10%??


On Feb 09 10:25 AM Marketer25 wrote:

> no liquidity on USL as mentioned by ROLEX
> it's got a 10% bid-offer spread so you'll be smacked by that when
> you try to get out...if you can get out.

Feb 10 11:47 AM

[ctbcgr:]

Could anyone tell me if UCO has these same problems. My understanding is that UCO is priced on the next month contract. Of course it has 200% leverage as well. I would appreciate if someone with expertse could tell me if UCO is a good play for someone that believes oil will be $60/bl by year end. Or, is their a better way to express this view. Thanks


On Feb 09 09:47 AM Market Folly wrote:

> agree with your thoughts that USL could be a better vehicle than
> USO due to diversification of owning 12 contracts rather than just
> the front month like USO does. Before we knew about USL, we wrote
> about how to play oil using ETFs/ETNs where we compared the 3 major
> plays: www.marketfolly.com/20...
>
>
> and then more specifically, focused on how contango affects these
> exchange traded vehicles and the article was mentioned in the FinancialTimes:
> www.marketfolly.com/20...
>
>
> so we'll have to interject USL into that same equation

Feb 10 11:54 AM

[Augustus:]

The further out the contracts, the worse the contango. USl just does not recognize the hit as rapidly. It may be much worse in the end.

Feb 10 11:58 AM

[thesnowjob:]

Wow. Nice job Matthew. You got USL rolling with 600,000 volume today. I like it. Tomorrow I'm switching into USL

Feb 10 05:59 PM

[roadstar:]

I'm not following why it is necessarily a mistake. Really USO and USL are just different calls on how the spot price would pan out, esp. relative to the futures price.

There's no free lunch and the article sounds lke USO is inferior to USL. If so, wouldn't you short USO and buy USL to certainly make money? Spot prices change, the level of contango/backwardation changes, each represents a different call on a relative basis, doesn't make one better than the other...

Feb 10 07:21 PM

[Dan Sanders:]

The readers have mentioned all the obvious negatives above USL vs. USO
No Liquidity on USL
No volume at all try to get out and take up to 10% hit on the Bid /Offer
and what nobody mentioned here is the fact that in today's Feb. 10. 2009
trading where USL longs got hit 9.50% from the days high
whereas USO longs lost only 8.50% the fact is
Once Oil starts spiking and making it's move it will leave
any other investment out there today in the dust
you must have faith and stamina or quit this game
stay with USO and show this comment
3 Months from now

Feb 10 10:21 PM

[peterjohnz:]

I have a novice question. Can you short EFTs (or ETNs) like USO?
I tried and my broker rejected the trade.

Would not USL be superior to USO as long as contango is in affect?
I would agree with roadstar if roadstar could show how USO would be superior to USL while the market was shifting to a less severe contnago.


On Feb 10 07:21 PM roadstar wrote:

> I'm not following why it is necessarily a mistake. Really USO and
> USL are just different calls on how the spot price would pan out,
> esp. relative to the futures price.
>
> There's no free lunch and the article sounds lke USO is inferior
> to USL. If so, wouldn't you short USO and buy USL to certainly make
> money? Spot prices change, the level of contango/backwardation changes,
> each represents a different call on a relative basis, doesn't make
> one better than the other...

Feb 11 05:17 PM

[peterjohnz:]

Total contango is worse but an investor would be interested at the rate of contango per month.


On Feb 10 11:58 AM Augustus wrote:

> The further out the contracts, the worse the contango. USl just
> does not recognize the hit as rapidly. It may be much worse in the
> end.

Feb 11 05:23 PM

[peterjohnz:]

ETFs can be shorted according to www.lyxoretf.com.hk/ad...


On Feb 11 05:17 PM peterjohnz wrote:

> I have a novice question. Can you short EFTs (or ETNs) like USO?
>
> I tried and my broker rejected the trade.
>
> Would not USL be superior to USO as long as contango is in affect?
>
> I would agree with roadstar if roadstar could show how USO would
> be superior to USL while the market was shifting to a less severe
> contnago.

Feb 11 05:56 PM

[RISA:]

how is the number 13.4% be determined ?
Whammo presto, the holders of USO lost 13.4% of their exposure to crude oil.

Feb 11 10:00 PM

[peterjohnz:]

I think it comes from the decrease in # of oil contracts but I get a 13% decrease from 100*(84378-73444)/8437...


On Feb 11 10:00 PM RISA wrote:

> how is the number 13.4% be determined ?
> Whammo presto, the holders of USO lost 13.4% of their exposure to
> crude oil.

Feb 11 11:57 PM

[peterjohnz:]

OK roadstar, I shorted USO and went long DBO (similar to USL). I will see how it works out.


On Feb 10 07:21 PM roadstar wrote:

> I'm not following why it is necessarily a mistake. Really USO and
> USL are just different calls on how the spot price would pan out,
> esp. relative to the futures price.
>
> There's no free lunch and the article sounds lke USO is inferior
> to USL. If so, wouldn't you short USO and buy USL to certainly make
> money? Spot prices change, the level of contango/backwardation changes,
> each represents a different call on a relative basis, doesn't make
> one better than the other...

Feb 12 11:17 AM

[peterjohnz:]

Here is another article on this subject:
seekingalpha.com/artic...

Feb 12 04:21 PM

[peterjohnz:]

Here is another article on this subject:
seekingalpha.com/artic...

Feb 12 04:39 PM

[fgh_21:]

it could only buy 73,444 April contracts...

Regarding the above , it should be 73789. My caculation as follows :
(84378*40.42)/46.22=73789

and after the roll date , the total value is not change since the new price for oil futures is 46.22
Total value : 46.22 * 73789=3410527
The total value before roll date is 84378*40.42 = 341058
So I think the total value is unchange becaue April contract has higher price compared to March contract.

Mar 25 12:33 PM