Winners and Losers from Oil Contango

Contango is one of the simplest arbitrages in the markets: you buy oil today, contract to sell it at a higher price in a few months' time, and just sit on it in the interim. The problem is finding a place to store it: oil traders will use up all available storage capacity very quickly so long as contango persists. Thankfully, they have a steady stream of cash they can use to build ever more barges: not just their profits from the contango trade, but also all the money pouring into oil ETFs from schmuck retail investors looking to "diversify" their portfolios.

Izabella Kaminska has a gloriously geeky 2,300-word blog entry on what she calls the "passive self-propelled pyramidization" caused by the structure of the USO fund:

Oil market participants win precisely because they can play the contango trade effectively and predictably. Retail investors just lose and will continue to do so until either the contango disappears or the oil price shoots up beyond the rate of their losses. Yet many analysts agree the oil price is unlikley to ascend much higher while the contango is in place, and as Schork highlights, the contango is unlikely to disappear while the market can continue to benefit from its structure.

Kaminska's great at explaining that the bigger USO gets -- and it's huge already -- the more inefficient it gets, and the more its very structure exacerbates the contango which is costing it dear. If you want to bet on oil, maybe it's easier to just do it the old-fashioned way and buy oil stocks instead.

Comments

[HiSpeed:]

It's a shame that US oil companies are pulling back on exploration. No doubt the volatility of oil prices and changing energy policy out of Washington are among the concerns.

Meanwhile, China - having a vision for the future - is planning for the future by investing at fire-sale prices. When the next energy crises rears in head, we will be looking back to these days only to see opportunities wasted, and focus on the wrong concerns regarding energy policy.

Feb 25 04:42 PM

[Heaven, Hel...:]

Good article. The cycle of the widening of the spread between the prompt month and prompt + 1 futures contracts during the large oil ETF's "roll forward times" followed by the invariable narrowing of the spread and eventual "rewidening" around the next roll time is really taking its toll on the returns of retail investors. Sellers of this spread are killing them. The ETF's positions within the context of the overall open interest have gotten too large for their own good and they are getting "front run" a la Metallgesellschaft.

Feb 25 05:14 PM

[ETFDesk dot...:]

that was prob the best synopsis I've read on the subject so far. Kudos for keeping it so simplistic.

Feb 25 05:18 PM

[User 280726:]

"money pouring into oil ETFs from schmuck retail investors".....

AND the farce of Oklahoma pricing.

Feb 25 05:27 PM

[2contango:]

USO certainly has worked well for short positions using options.

Feb 25 06:18 PM

[Hedged In:]

Felix, in addition to the contango problem, USO was getting creamed by front-running: seekingalpha.com/user/...

Feb 25 06:29 PM

[Trading Alpha:]

Contango is still there but it has been almost cut in half in just the last two weeks suggesting a more bullish move towards backwardation.

Feb 25 07:17 PM

[scotty1560:]

uso has certainly been a loser for me..
sold half my position recently and will wait to see how this this stock market
thing plays out..

If the dow is headed towards 4000-5000, then it is probably best to wait
another year or two on oil..
world economies are toast..
who is to say oil can't stay in a $25-$50 range for 3-4 years?
construction, travel, services, manufacturing..all dead in the water

Feb 25 07:36 PM

[Ergo:]

Good concise article. Too bad about all the billions poured into these ETFs recently from folk who haven't realized how this works.

Feb 25 07:51 PM

[dieuwer:]

Look at a chart of USO over the course of 8 months. How can anyone seriously contemplate to go long USO? If anything, you want to short USO.

I'm a little guy, but I have my own brain (IQ 120+). I won't touch USO with a foot-long pole...

Feb 25 09:57 PM

[beenburnedt...:]

Hear, Hear. The authors concluding comments are spot on.

Feb 25 10:30 PM

[M dub:]

Getting picked off on the roll, nice - you can't make this stuff up. Even putting aside the flawed concept in this etf, i'll bet most of these retail idiots think WTI futures actually move the world crude market as if they were UST or S&P futures. If there is so much of this dumb american speculative money floating around, how on earth can we even be close to a bottom in US asset prices? Jesse Livermore would be having a nice laugh about now.

btw, isn't Cushing at capacity for all intensive purposes? I don't think there's enough there to crash the spot market but it does make the carry trade more difficult.

Feb 26 12:43 AM

[Nikola:]

Hear, hear here as well. It's twice as bad on DXO. I lost some money there and was trying to figure out why. In the end I concluded it's all a scam, but couldn't quite put all the strings together. Now it makes sense.

Feb 26 03:33 AM

[Nikola:]

This is why I am... em... not concerned for the market and financial services companies long term. (?!?!)

Sure the derivatives imploded taking us all with them. But surely there's always a way to find a loophole and cheat.

So long as there is no oversight on building, new pyramids will be built inside our cities.

It seems like ETFs are becoming the new CDOs. A black box, offering a "schmuck retail investor" diversified risk exposure to something he normally cannot trade easily. And leveraged too, for your convenience.

They are not even waiting until we recover from the last fiasco of "packaged financial instruments." They renamed it, opened their office across the street, and kept selling.

Feb 26 03:49 AM

[The Greates...:]

It is the greatest rip off of the world in our day. Like the last comment, there will always be ways to cheat and find loop holes.

Feb 26 08:10 AM

[notsosmart:]

been saying it for years. its all ponzi.it will continue as long as the dumb-dumbs put their monet in. at least at the casino they bing you a drink.

Feb 26 09:04 AM

[billp37:]

Oil to go higher?

"In recent days, four key developments have clicked in to edge Iran and Israel much closer to a military denouement with profound consequences for American oil that the nation is not prepared to meet.

What has happened? ...

First, Iran has proven it can successfully launch a satellite into outer space as it did on February 2. Teheran claimed, to the incredulity of Western governments, that the satellite was to monitor earthquakes and enhance communications. ...

Second, the International Atomic Energy Agency last week admitted that it had underestimated Iran's nuclear stockpile by about one-third. ...

Third, Iran has ramped up its enrichment program with thousands of new homegrown, highly advanced centrifuges. ...

Fourth, Binyamin Netanyahu has just become prime minister of Israel. He is determined to take action before - not after - Iran achieves its nuclear potential. ..."

www.jpost.com/servlet/...

Feb 26 09:47 AM

[Echo To All:]

"...money pouring into oil ETFs from schmuck retail investors..."

they don't really seem like schmucks today. Why insult so many readers by calling them schmucks instead of providing a solution or alternative?

since I was in USO, u called me a schmuck (and the many others in the name)... yet ur simplified recommendation of buy oil stocks makes u the schmuck today. uso is +4%, while most oil stocks are +1 (w/the exception of PBR).

(anyway... i'm ready for the 10 thumbs down from the reads who don't think their schmucks because they agree with you)

Feb 26 10:40 AM

[xsellside:]

"The Commodity Futures Trading Commission said Friday that it is looking into trading activity in the United States Oil Fund LP and other "market participants" regarding the Feb. 6, 2009 roll. That's when USO, the largest oil exchange-traded fund, last sold the current month futures contract and bought the next month contract in what's known in oil markets as the monthly roll. Since USO holdings account for about one-fifth of the Nymex front-month contract, that roll can pressure current month prices and raise the next month's prices. The ETF said recently it will change its procedure and use four days for the roll-over. USO fell 2.6% to $26.52 as oil futures fell sharply."

I'd like to hear some thoughts and discussion on this.

Feb 27 12:32 PM

[Chezfrederick:]

Good article, Thanks.

I posted the following comments 10 days ago on a previous article which appeared on the topic of USO volatility (How to Trade Oil ETF Volatility):

Excellent article... I have traded these ETF for 3 months with some success. The key word here is "Traded". I learned the hard way, that these are not buy and hold vehicles, as they don't track spot prices, and have an inherent built in decay factor when markets are volatile. This resulted in my confining these instuments, both USO and HOU/HOD to day trading activities. I wish more is written about their inherent poor design to warn other investors of the built in dangers. The volumes are reaching alarming levels where for example, the HOU volume topped 40 million on the day yesterday (Feb 10) easily making it the highest volume trade on the Toronto stock Exchange. (...and holds the Nymex front month future contract)

Now, past this initial trap, I had been wondering why the sudden, violent and sometimes very rapid (Less than 30 minutes) volatility in futures and ETF prices had been occuring... and would like to thank you for shedding light and providin another trade opportunity in a very well written article.

My final comment is that while it may appear that I had not read the prospectus, I had done so twice over... but while I could have inferred some of these effects by reading the documents, these issues were not laid out clearly enough for even an experienced investor. I wonder wether the regulators are aware of the issues with such ETFs and how they would react if this was brought to theit attention. Does anyone have some insight or views on this point? Feb 11 07:08 AM

I am glad to see that the regulators are starting to look into the impact of the oil ETFs... I hope they also look into the HOU as it volumes are almost rivaling those of USO, and they seem to roll over to the next month contract at the same time as USO.

I have determined that these ETFs are better shorted than held long as they approach the roll over period...

Please keep expanding on this topic. Great work.

Mar 01 06:11 AM