I recently wrote about a few ETFs that I was considering for the PeakStocks.com portfolio both long and short.
One of those names was the United States Oil Fund (NYSE: USO), one of the largest ETFs in existence, and because it is so large, this ETF represents 1/5th of the total trading volume on the U.S. Nymex Exchange for oil futures contracts.
In the course of researching this ETF for possible purchase, or shorting, I came across some disturbing bits of information regarding how the ETF trades, and its overall affect on the oil markets.
In fact, on Friday February 27th, the Commodity Futures Trading Commission (CFTC), opened an investigation into the USO, as well as other market participants, regarding the Feb. 6 “roll”, or sale of the expiring front-month oil contract and purchase of the successive month’s contract.
New to the USO story?
The USO is an Exchange Traded Fund (ETF) that seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil.
The fund invests in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges.
It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil.
In a nutshell, all things considered, the USO is a proxy for the price of oil, aside from its dependence on “rolling” the price of it’s contracts into future months, which can adversely affect its actual ability to “track” the price of oil.
Is the USO a Piece of Junk?
First a little background
As mentioned above, the USO was created as a proxy to track the price of oil.
When the fund was first created, its price was exactly 1-1 that of the current future’s month oil price.
That however has changed dramatically.
You see, the USO is a rolling ETF, which means in essence that every 30 days or so, the ETF has to “roll” into the forward contracts of oil BEFORE the ones it is holding expires.
There are other funds like the USL (NYSE: USL), which hold 12 month’s worth of contracts instead of just one so they merely roll one month but still hold the other 11, reducing price volatility and keep the fund more closely tied to the actual price of oil.
So, for the USO, if the ETF held say March contracts in the month of February, then at a specified period of time (for the USO it’s around the 6th of the month, but now over a 4 day period around that same time), the fund “rolls over” into the next month ahead of the one it carries.
In this example, say that it owned March futures contracts for oil at $40.
Then at or around the rollover date, the fund would have to sell all of it’s $40 contracts for March, and roll them over to April contracts that cost for example, $45. This part is pretty straightforward.
Here’s the problem with the USO: Rolling the current month’s contracts into the next month’s contracts, especially lately, creates what is called contango when the future price is higher than the current price.
Contango basically means that the price of the future contract is higher than the current contract, and thus, when the fund has to roll over into the next month’s contract, it has to pony up more money to do so, thus costing investors valuable gains, and actually LAGGING the performance of the underlying commodity it is trying to mimic.
Some of these losses are mitigated because the USO earns interest on the money it collects from investors, and because it only needs 10% of those funds to actually secure the futures contracts because of leverage.
By the way, the exact opposite can occur as well in what is known as backwardation.
In this case, the future contract costs LESS than the previous month’s contract, and thus the fund actually earns a higher rate of return than the fund it is tracking because of that.
Just to let you know however, since the inception of the USO, the fund has been in contango way more often than it has been in backwardation, thus costing investors more than they have gained as a result of the contract’s rolling over.
OK, so what?
Here’s the crux of the problem: because the USO has been in contango way more than it has been in backwardation, and by a much higher relative margin, what once started as a 1-1 ratio fund mimicking the price of oil, is now LAGGING the actual returns that you would have made with investing in oil and is now at about a .68 ratio.
This means that if you had invested $10,000 in the USO at its inception, that initial investment would now be worth about $7,000 NOT even accounting for any price movement in oil! This is just as a result of your loss of capital because of the way the fund is structured whereby it continuously rolls into future months of oil, losing a little on each trade.
Think of this as akin to currency erosion that is taking place right now around the world, whereby if you were invested in stocks in other markets, say in England, the loss of the British Pound to the U.S. dollar (about 30% in the last 6 months or so) would mean that even if your investments broke even, you would essentially still be DOWN 30% because of the erosion in the value of the underlying currency with which you purchased shares in those investments.
Before I started really looking into the USO, I never knew about this as an issue, and now that I have fully developed my thesis and investigated further I see that this is no way to play oil, aside from other problems that the fund is having, as I’ll go into more below.
More Bad News: CFTC Investigates USO and Other Funds
Large fund now able to move markets
To add to the contango scenario mentioned above, there is another worry with the USO that most people don’t even realize: the fund is so absolutely huge, accounting for 1/5th or more of the total Nymex contracts, that when the fund rolls over, that in and of itself moves the price of oil!
The price action lately is usually to move the expiring contract price downward as the fund sells those contracts, and upward for the new contracts that the fund is now purchasing, thus further eroding investors' gains and accelerating their losses!
As a result of the price movement and volatility, the USO has now changed its procedures to unload and buy these contracts over a 4 day period of time, rather than the usual 1 day.
In addition, on Friday February 27th, The Commodity Futures Trading Commission (CFTC) said its enforcement staff is investigating the United States Oil Fund LP and other market participants regarding the Feb. 6 “roll”, or sale of the expiring front-month oil contract and purchase of the successive month’s contract.
On Feb. 6, March oil futures, the front-month contract at the time, lost more than 2% in trading on the New York Mercantile Exchange as USO rolled its holdings into the April oil contract.
Prices in the March contract slid below $40 a barrel in the next trading session for the first time in three weeks.
Some investors believed the selling of USO, which held about 20% of all March contracts, contributed to the price downturn.
Now while I don’t foresee any real damage or changes coming out of this “probe”, it does illustrate just one more problem with the fund in that it is so large, that it now can move markets by itself, and not only that, but by the very nature of that knowledge, move markets as others hop on board and try and piggyback the gains/losses and rollovers that the fund is trying to accomplish thus adding to the overall volatility in the oil market.
So, IS the USO a Piece of Junk?
Yep, I think it is…here’s why:
- Contango too much to overcome: The very fact that the USO rolls over its contracts every single month creates a lot of extra price erosion in the underlying value of the fund.
Because we’ve been in, and will continue to be in, contango for a long period of time as oil prices are expected to rise, and future contracts are being held hostage for much higher prices, our investment in this fund would continue to be eroded over time, and buying and holding would in essence lose us money even if the price of oil stayed constant.
Sure, we could experience an extended period of backwardation, or the opposite of contango, and make money as the contracts are rolled over above and beyond the price of oil, but here’s the thing: if the future contracts are selling for LESS than the current contracts, doesn’t that mean that the price of oil is declining, and therefore, no matter what amount we are making on these contract swaps, we are still losing money on the underlying investment as oil prices decline?
Again, I don’t like having to overcome an extra handicap when trying to beat the overall market’s returns.
- No pricing advantage: As a result of the fund’s size and timed roll over dates, we are completely losing our advantage over Wall Street and other traders in “knowing” or taking advantage of something that not too many know about, and thus exercising our key differentiators as individual investors.
That has been completely removed as a result of the USO’s size, roll over timing, and associated hoopla and market coverage related to oil, the fund itself, and commodity futures trading.
We’re essentially small fish being carried away by the tide and there’s nothing we can do about it.
This would be fine with a small or micro-cap investment that we’ve thoroughly researched and investigated and can simply buy and hold to wait for our investment thesis to play out, but there isn’t such an advantage with the USO.
Can I still play the USO?
Sure, for short term, week-to-week movements, it’s still a decent proxy for oil, but anything longer than that, and you start to run into the above mentioned problems with the rollover and the size of the fund eating into your gains, and exacerbating your losses.
For traders, right around the 6th of each month when the USO exits its old contracts and enters the new ones, there is heightened volatility as well, and therefore, something that might interested those with a day trader mentality, or for short term price swings.
Are there other ways to play oil?
Yep, the other ETF that trades on the price of oil but uses 12 months worth of contracts, is the United States 12 Month Oil Fund (NYSE: USL).
This fund seeks to replicate the changes in percentage terms of the price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the average of the prices of 12 futures contracts on crude oil traded on the New York Mercantile Exchange.
The fund consists of the near month contract to expire and the contracts for the following eleven months, for a total of 12 consecutive month’s contracts.
When calculating the daily movement of the average price of the 12 contracts each contract month will be equally weighted.
This is a much better way to protect yourself against contango and backwardation as the risk is spread out over a 12 month period, and only the front month is rolled over thus avoiding not only large price fluctuations as a result of the total volume of contracts, but also because all 12 months are equally weighted, month to month changes in contango or backwardation won’t affect the fund as heavily.
In doing further research into how I could play oil and trade this volatile but potentially lucrative commodity, I dug up some disturbing facts about the USO that lead me to believe that it is not worth our investment, and is a literal piece of junk.
I will be removing it from my watch list, and instead replacing it with the much more balanced USL ETF that trades on the next 12 months of oil prices, rather than just one month ahead.
It’s just another way of playing both sides: the changes in the price of oil both up and down, and the relative stability of all 12 future month’s contracts which smooth out the price swings and the contango and backwardation possibilities and make the investment more suitable for a buy and hold strategy since market timing for oil is nearly impossible.
My advice is to play oil utilizing the USL vs. the USO unless you are a seasoned trader that has specific reasons for trading the USO such as the price movements associated with the rollover on or around the 4 day period of the 6th of each month.
Want more? Read my initial write-up on the USO and other ETFs by clicking here.
It’s hard enough to beat the market’s returns - we don’t need an additional handicap to make things harder.