Is the USO ETF a Piece of Junk?

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.

Bottom Line

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.

Comments

[xsellside:]

Very nice work, Chris. And it looks like you are moving markets today as USO is down 8.95% as I type this... or is that the contango... or fundamentals? We shall never know.

Mar 02 12:34 PM

[Wawizzle:]

If the contango is ruining the asset USO then how did it climb to $120 matching the $147 barrel oil? I feel like I'm misunderstanding something.

Mar 02 01:23 PM

[Heaven, Hel...:]

This is a very good article. The cycle of the widening of the spread between the prompt month and prompt + 1 futures contracts during USO'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. Spread traders who are sellers of this spread have been killing them.

USO positions within the context of the overall open interest have gotten too large for its own good and they are getting "front run" in a manner similar to Metallgesellschaft before them, exacerbating the very condition (contango) that plagues them.

Mar 02 03:47 PM

[Ed's perspe...:]

I've a done a bit or analysis on this also. The BOTTOM LINE ... in the small print of ALL of these futures / leveraged etf's ..... they establish pricing for use by a day trader. They admit that there is a lot of "friction" i.e. rolling costs to re-establish the price of these products every day and that the result is NOT a mirror image. You have to recognize you are subject to volatility premium ..... the absolute price of oil (or any other tracking etf) may be EXACTLY the same on two different days but the market direction will reflect the optimism/pessimism pricing just like options trading.

Buyer be informed ... and trade accordingly.

For my PERSONAL use ... I've found buying in the middle of a mild trading day (not the first or last hour) has produced the short term returns/correlations I've desired.

Mar 02 05:51 PM

[Gary Gallo:]

First of all the WTI is no longer cheaper. And as long as it rises with WTI and falls with it, with good liquidity honestly what does it matter.

Mar 02 09:44 PM

[Tatertot:]

would it be possible to go long USL and short USO? That way, you essentially hedge any movements in the price of oil, but gain from the contango. What kind of returns could you expect from this?

Mar 02 10:25 PM

[Fighting Yoda:]

Very good article, explains the dynamics of the fund. Thank you.

Lot of these ETFs are not at all well understood – how they work – and are they actually tracking. The fund promoters never publish any such data. Investors in general are completely ignorant and unable to build a correlation between the ETF and the underlying commodity. Some amount of tracking is lost by expenses that are incurred, even though the interest earnings should mostly offset the expenses. So if the author’s analysis (and math) is correct – you are losing money (a lot) owning the fund.

Another oil fund ETN that can be looked at is OIL (I personally have not researched it much yet).

Another set of ETFs the double shorts are complete scams – they do no tracking at all – they simply track on a daily basis. Even over a few days, not to mention a week or a month, the tracking is completely lost. The underlying index could be down by 50% and the double short could be down by 50% (it should have gone up by 100%). Double shorts are strictly and ONLY meant as day trade, anything beyond is a complete disaster. These should be banned, SEC is inundated with complaints, and also Cramer is on the case.

In general be extremely wary of all these new exotic ETFs – they do not have a track record and the dynamics are not at all understood. Even the GLD expenses’ (storing physical metal) erodes its ability to track.

It is extremely surprising and disappointing that much analysis and research has not been devoted to ETFs, despite the fact – these have become so large and even professionals use them a lot. This would be just another example of professionals not doing any research and simply handing over the money to Madoff.

Mar 03 12:41 AM

[skye001:]

Let's do the math..... With contango, your number of shares controls fewer barrels of oil, true, but in dollar terms you are even if the futures prices are constant. Consider this scenario:

March oil $40
April oil $50
May oil $60

Let's say you buy $4000 worth of USO in early March. You then "own" 100 barrels of oil at $40 ($4000). If the prices stay the same, when the contracts roll over to April, you only own 80 barrels of oil, but since the price is $50, you still own $4000 worth. Same for May, when the contract rolls over, you own 66.67 barrels at $60. You still have your original $4000 investment intact.

Now it is true that you haven't made any money even when oil went up from $40 to $60, but this isn't the right way to look at it. Oil futures for May were already at $60 when you made the investment; they didn't go up or down.

Mar 03 12:44 AM

[Fighting Yoda:]

Skye001:

Your logic is wrong.

You do not need $4000 to setup a contract for 100 barrels of oil @$40 – typically you just need the margin amount about 10% of the underlying commodity – let’s say $1000 only. The balance $3000 – should earn interest income and offset the expenses of the fund (hopefully that is the case).

When the contracts rollover – you gain or lose based on the prevailing price of oil. A $40 contract on expiry – if oil is at $50 – you would gain about $10 (less expenses). That is what the contracts are all about.

The fund price should track the price of oil, but as the author has explained due to expenses, contango/backwardation etc – the fund is unable to track on any long term basis. So the net result is a random price movements on longer term basis ( a few days and beyond).



On Mar 03 12:44 AM skye001 wrote:

> Let's do the math..... With contango, your number of shares controls
> fewer barrels of oil, true, but in dollar terms you are even if the
> futures prices are constant. Consider this scenario:
>
> March oil $40
> April oil $50
> May oil $60
>
> Let's say you buy $4000 worth of USO in early March. You then "own"
> 100 barrels of oil at $40 ($4000). If the prices stay the same, when
> the contracts roll over to April, you only own 80 barrels of oil,
> but since the price is $50, you still own $4000 worth. Same for May,
> when the contract rolls over, you own 66.67 barrels at $60. You still
> have your original $4000 investment intact.
>
>

Mar 03 01:30 AM

[Leonard the...:]

Skye001: Good point.

The way it has been working that I have seen is that the front month is getting pushed down before "the roll" and the next month prices are being pushed up artificially.

Once the rollover takes places the price quickly starts to come back down towards the current months price thus narrowing the contango.

This is hurting USO.

Full Disclosure: I am short USO

Mar 03 08:51 AM

[Chris Ferna...:]

I don't think there is anything more I can add that you guys haven't already covered really well.

As for suggesting shorting USO and going long USL, that is not a good idea at all, even for a day trade.

This isn't like locking in gains on the "A" or "B" shares spread of a company.

Again, short term, these are fine ways to play a few week's worth of rapid oil price movement, even a few days the way things have been going lately in oil and other commodities, but longer than that, all bets are off.

Chris

Mar 04 01:21 AM

[Chezfrederick:]

Excellent article, thank you. I would like to make a couple more points on the subject:

It appears to me that shorting USO on roll over days, when your outlook is for a decline in oil prices could pay off hansomly reaping double the reward. the first is making the right call on oil, and the second is capturing the inherent decay in USO... the added bonus would be the market effect on oil futures as the roll over takes place. I would only hold the short for the duration of the roll over...

One other comment, USO is not alone there are others, In Canada HOU is listed on the Toronto Stock Exchange and it is huge. Since January it was comanded the highest trading spot on the exhange almost daily, whth volumes reaching in excess of 50 million at one point and it holds mainly the forward contract of the NYMEX futures as well. Further it's roll over dates coincide with the USO... This is added pressure on influencing the contracts market prices. I hope the regulators looking into USO also extend their review into HOU, and or illicit the help of Canadian regulators for the task. The decay rate of the HOU has been even more alarming that USO when compared to the spot price of oil.

Thanks again, and I hope all this increases investor awareness that all ETFs are not safe investing vehicles and it's critical to look under the hood and can be misleading.

Mar 04 07:31 AM

[Ryan Farley:]

I'm glad to finally read somebody break this down. UCO, proshares 2x oil etf uses the same strategy. I bought it when oil was around 35, and just sold it today where oil is about 50. Now I should be about 80 percent ahead, but I just about broke even. Its this problem, combined with the normal risks of 2x etfs. Some days oil would be drastically up and UCO would be down! Utterly absurd.

Thanks for the explanation Chris; I knew something was sketchy about these contracts, but I'm glad somebody finally broke it down.

Mar 19 12:46 PM

[justanother...:]

Looking at the charts of USL does not show that USL is doing any better than USO. Both USL and USO are currently at $32 while oil is at ~$52/barrel. On top of that, during the height of oil prices in July 2008, USO reached $117 while USL only reached $87.

Maybe I am missing your point.

Mar 27 04:18 AM

[goldstock:]

I understand contango and why its a bad thing. You sell something at $54 and then buy it back at $55. But I don't understand why it's bad in USO's situation. If you start back in January the price of oil was in the low 30's, so we sold at say 31 and bought back at 33. But then didn't we sell that at like 38 in February? And then the last go around we sold sold at 49 and bought at 52, but go back a step, we bought at like $42 and sold at $49. And this time we bought at $52 and are selling at $58.

Now if I bought widgets for $10 and sold them at $15, that would be a pretty good deal. And then if I went and bought thing-ama-jigs for $17 and sold them for $20, we would all be happy. And who would have a problem if next month I bought watchamacallits for $22 and sold them for $28?

Isn't that what we've been doing with Oil since January?

May 07 09:41 AM

[Ihaveyourmoney:]

Too bad you posted this piece of shit article only days before USO went up 80%. Get out of the market noob. Its clearly no place for you.

Jul 06 12:51 PM

[eforcaster:]

Contango and backwardation problems exist for anyone trading future's contracts, not just USO. Besides net asset value per share, the market perception becomes very important in the formation of the market price of those ETF. When oil price was at its peak, the market price of USO was like 80% of the actual crude oil price, but now it is only like 55% of the crude oil price. The majority of this huge discount is probably due to the bearish view of oil price than the result of contango. If USO publishes its NAV daily, things will become clearer.

Jul 15 02:51 PM

[User 449403:]

uso is a great etf to trade bought in may @ 28 sold one month later @ 38 ....contango and backwardation my nuts....

Jul 16 09:34 PM

[User 449403:]

true that.......


On Jul 06 12:51 PM Ihaveyourmoney wrote:

> Too bad you posted this piece of shit article only days before USO
> went up 80%. Get out of the market noob. Its clearly no place for
> you.

Jul 16 09:36 PM