USO: Death by a Thousand Contangos 9 comments
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USO is not a long-term proxy for crude oil. Buy-and-hold investors who do not understand the structure of USO will underperform crude. Surprisingly, many investors, judging from their posts, don’t know this even though the information is readily available on the USO web site and elsewhere.
USO holds all its funds in next-month WTI futures. For example, USO started out February fully invested in the March WTI contract. Midway through February USO rolled all its funds into the April contract. The rollover has all been done on a single day, but USO recently decided to rollover over a multi-day period to minimize market impact.
When oil is in contango, far months are more expensive than near months so USO’s rollover loses money. The loss is mitigated somewhat by the interest USO earns on its funds (only 10% of funds are needed to secure a contract). Also when oil is in backwardation the rollover makes money.
However, over USO’s history, oil has been in contango more often than backwardation. Consequently, over its history, USO has lost value relative to oil. The ratio of one USO share to the price of crude was 1.0 when USO was launched. Today the ratio is 0.68. It’s essential to appreciate that this process has NO intrinsic lower limit: a prolonged period of contango can drive USO down indefinitely even while spot oil remains unchanged.
Anyone considering a buy/hold strategy for USO today should be aware that oil has been in very steep contango and likely will remain thus for some months to come. This has been very costly to USO in recent months as a comparison of crude prices to USO readily shows.
In summary, while USO is a useful short-term oil proxy, it should not be used as a long-term proxy without some strategy to minimize value erosion through contango, such as writing monthly covered calls.
Stock position: None.
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This article has 9 comments:
If you want just the refiners and processors its OIH.
On Feb 24 10:59 AM tomatden wrote:
> Thanks for the info Milan. Is there another ETF or equity you would
> suggest for someone wanting to go long on crude?
Here is one of the articles that mentions it
www.etfdesk.com/headli...
More on USL: www.etfdesk.com/fundDe...
I am not aware of any way to directly go long crude (renting storage at Cushing aside). However, the smaller oil producers (for example ARD, APA, SU) have near-perfect correlations to spot oil, so you may consider a basket of these stock. Also, DBO and USO work when oil is in backwardation.
On Feb 24 10:59 AM tomatden wrote:
> Thanks for the info Milan. Is there another ETF or equity you would
> suggest for someone wanting to go long on crude?
Would USL or OIH be good mid to long term investments? I got in USO @ $39.00.. Should I continue to dollar cost avg down OR where do you see USO going in the short term??
Really its performance should be compared to the performance of hiring an oil tanker to hold oil and wait in the Caribbean or somewhere. If USO under performs compared to the tanker, then there's an arbitrage opportunity by shorting USO and hiring a tanker, then covering later by selling the physical oil and covering the short.