USL, USO and the Contango Collapse

By Matthew Hougan

The markets are moving fast, and I have a lot to account for, starting with my suggestion that investors buy USL instead of USO.

As Jim so nicely pointed out in his blog on Wednesday, my suggestion back in February that investors buy USL and not USO was wrong. Anyone who read my blog, did their own research and then followed through on that trade got killed. For that I apologize. Please know that I do not wear it lightly.

The flaw in my analysis was that I did not think contango would collapse as quickly as it has. When I wrote that blog, the near-month oil futures contract was trading at a 13% discount to the next-month contract. Today, that discount has narrowed to just 1%.

That collapse — one of the most violent in history — benefitted USO, which tracks the near-month futures contract. And it hurt USL, which buys longer-dated futures. The math can be complicated, but basically what happened was that the near-month contract that USO tracks had been trading at a discount ... and that discount disappeared.

I knew this was a possibility. A few people even suggested it in comments to my blog. I was betting that any collapse in contango would take place over months, not weeks. Contango was a systemic drag on USO, so every month it persisted would harm USO's performance. If the collapse in contango had been spread out over the space of a quarter, investors in USL would have outperformed, because the drag would have outweighed the collapse of contango. But contango collapsed over the course of a few weeks, so it overwhelmed the contango drag.

The question for investors is, what happens next? The answer is, I don't know. Will the oil futures curve continue to reverse? Will oil switch from contango to full-on backwardation? Will it stay the same? Will contango come back? I'm not sure. It is a complicated market.

Toward this end, a reader asked on Jim's last blog why USO doesn't seem to track the price of the oil. The writer — zonacorp — noted that oil was trading at $51/barrel and USO was only trading for $29.61.

The answer, zonacorp, is exactly the effect I mentioned earlier: contango. There are three factors driving returns in USO: the change in the spot price, contango/backwardation and the interest income that USO receives. USO has under-performed spot oil because oil has been in contango for most of the time that USO has been trading.

A lot of people, like zonacorp, ask me what the best way to invest in oil is. What they mean is, how can I track the spot price of crude oil? The answer is that you can't: Aside from buying oil and storing it in your backyard, the best you can do is futures or futures-based ETFs. But people don't want to deal with all the contango, backwardation and other complications.

The suggestion I would make is to think about what bet you really want to make. I get the feeling that most of the people buying oil are making a bet that it will rise over the next year or two. One way to capitalize on this is to purchase long-dated futures contracts. You can see all the NYMEX oil futures contracts here.

You can buy a December 2010 contract for about $65/barrel. If you think oil will be above $65/barrel by 2010, this is one way to profit from that. You can go out further, too: December 2016 oil futures are trading for $79.93.

Note that liquidity in these longer-dated futures contracts is very, very thin, so trade carefully.

If you want to stay out the futures market, an alternative would be the MacroShares Up Oil Trust (NYSE: UOY). Although it's difficult to say how UOY will trade over the next few years, the security matures in December 2013. When it does, investors will be paid the full value of the February 2014 oil contract. So if you're willing to hold until then, you can count on that. (One caveat: The security will hit a ceiling and be liquidated at full value if oil tops $200/barrel.)

The oil market is complicated.

Comments

[Larry House:]

It is refreshing to hear such accountability for being wrong. We all are, but one seldom hears it confessed.

Do you still think USO is a poor way to invest in oil? I have some money in USO just to keep oil in the portfolio. I will not go the futures route. Is UOY better than USO?

Mar 20 11:44 AM

[SteadfastMason:]

UOY does not seem to have much volume. That translates to me to be possibly tough to sell, if needed.

I hold DXO, a 2X Oil Bull ETF and ERX. it is a 3x Bull, Energy ETF.


SteadfastMason

Mar 20 12:04 PM

[Abraxas:]

Matthew,

No apology necessary. Your suggestion to buy USL instead of USO was NOT wrong. It was, and it is still the correct call. It is just that you are now looking at your advise a few weeks out, an exceedingly short time frame to come to your conclusion.

Tactically, it was the wrong short term trading advise; simple bad timing. Strategically, though, it was good investment advise.

Clearly, most people wanting to have exposure to oil would still be better off with USL, which spreads out the risk, than with USO. USO is a good short-term trading tool but a dangerous long-term investment one. The only possibility for USO to outperform in the long run would be to have long term sustainable backwardation and that is not likely to happen.

Wouldn’t you agree that, in the long run, oil contango is still the most likely scenario and, thus, USO will likely continue to suffer from this systemic drag and underperform? Stick to USL.

Mar 20 12:33 PM

[samwise:]

Even Spock made a guess. You say you don't know what happens when a contango reverses so violently in such a short period of time. Yet I think an educated guess in here would tell you that this is a signal we could get another speculative run in oil. If you thought everything was in line for the run at $150 last year what conditions have changed in the past six months to say we can't have a return to that number and even higher? If you say "the obliteration of Wall Street" I'd say that means the obliteration of the one group of institutions charged with keeping inflation (other than their own) under control. And now we have...ICBM Ben?!!! Next stop: attempts at nationalizing oil majors.

Mar 20 12:36 PM

[user225084-...:]

Can you provide some numerical measure of how the contango has reversed?

When I look at the futures prices today the slope of the forward curve does not seem all that different than it did 2-4 weeks ago.

Is there a site that plots a "contango curve" for each and every date, so that we can more easily compare and see for ourselves?

Mar 20 12:58 PM

[Prudent Man...:]

Anyone who prices a future higher than the spot plus carrying costs is speculating on a fundamental or emotional change. May as well go to Vegas. At least you can see some pretty girls.

Mar 20 01:15 PM

[Between The...:]

The contango plus low price level has caused lots of production cuts and oil hoarding, hoping that prices would increase and seeing the arbitrage opportunity for carrying the crude and selling later. Now prices are up (all that crude was taken off the market) and there exists a strong temptation to turn the taps back on and start unloading all of that hoarded crude. Changes so rapid in the futures market suggest some of this crude outside of the normal production flows is moving around. However, predicting the future of crude is so difficult with the specter of FED printing, demand destruction due to recession, environmental movements against carbon-emission, and the political instability in oil producing nations.

Mar 20 01:42 PM

[rdd:]

I have made money on USL since I bought it in January. I think it is a better vehicle for someone with relatively long time horizons than USO.

I also own GSG where the oil component is similar to USO with the contango effect.

I own LSC which has been short-neutral on energy so it has been out of the CTI index for the past few months, but down the road I expect it will come back in as a long. LSC is the only ETN that I own as I like the CTI index for long-term commodity investing and HSBC is probably the most solvent really large bank in the world today, so the credit quality is acceptable.

All in all, I think that USL is a reasonable alternative investment component of the asset allocation in a long-term investing strategy. Columns like yours and the ones in Hard Asset Investors were very useful for us non-professional traders to understand some of the nuances of these various investment products.

A much bigger error would be pushing either USL or USO in July 2008.

Mar 20 01:59 PM

[tunaman4u2:]

I read your article when it came out & researched it as a result too. I sold USO early as the contango was insane.
Basically if oil stayed at the same price I would have gotten smoked. No one could have predicted that oil would hit $51 bucks so quick. Even with that USO is still $30 bucks or so.
I took a lot from your article, not a prediction of oil prices, just that contango kills USO if oil prices stay the same (as well as contango). Thats true, you were right on for informing us as such.

Mar 20 02:00 PM

[BearvsBull:]

If you are considering USO, you need to know that you are considered a partner in a partnership and as such will get a schedule K-1 at the end of the year that may affect your taxes.

Mar 20 03:10 PM

[Mad Hedge F...:]

This is important. OPEC voted to keep quotas at their current reduced levels, spurring crude to top $51 yesterday, a two month high. At this point, helping revive near comatose importers with low prices is more important for members than squeezing out a few more dollars in revenues. The cartel has done a better job keeping cheaters in line than in the past, with Saudi Arabia doing the heavy lifting on production cuts. We are backing off a couple of bucks today because of a surprise 3.2 million barrel jump in gasoline inventories. But the enormous contango has started to shrink, suggesting that the $32 low we saw in December is looking safer by the day. Could crude’s revival be another early hint at a recovery in the broader global economy?

Mar 20 03:53 PM

[User 379910:]

All of you should check out OIL. This is a great way to get close to the spot price of WTI and not have to deal contango or backwardation issues. It can still cause some pain. If you check out the price action from December of 2008 you can see what I mean versus the next months price. The real issue is you need to decide how you will invest in oil and stick to it. If you want to play 30 days out, USO is one way, but if you just want the spot on Texas Tea, OIL is the way to go.
Good Luck!

Mar 20 04:31 PM

[Pink Panther:]

User 379910:
OIL is no better than USO regarding contango losses (OIL vs WTIC):
stockcharts.com/h-sc/u...:$WTIC&p=D&yr=...

In comparison, here is USO vs WTIC (looks the same as OIL)
stockcharts.com/h-sc/u...:$WTIC&p=D&yr=...

However, USL is much better at tracking WTIC:
stockcharts.com/h-sc/u...:$WTIC&p=D&yr=...

Mar 20 06:00 PM

[Pink Panther:]

Sorry, the links got broken somwhow, here they are again:
stockcharts.com/h-sc/u...
stockcharts.com/h-sc/u...
stockcharts.com/h-sc/u...

Mar 20 06:04 PM

[Pink Panther:]

It's incredibly difficult to post some hyperlinks here on this site!
Again:
stockcharts.com/h-sc/u...:$WTIC&p=D&yr=...
stockcharts.com/h-sc/u...:$WTIC&p=D&yr=...
stockcharts.com/h-sc/u...:$WTIC&p=D&yr=...

Mar 20 06:06 PM

[Pink Panther:]

I give up !!!
(°_°)

Mar 20 06:08 PM

[BxCapricorn:]

The links work, they simply get shortened. I've been there myself. It's unique to this site.

Mar 20 06:32 PM

[Pink Panther:]

Yeah, it's strange...
I guess, it's the Dollar sign or the hyphen or both which splits the links in two.
My point is to show OIL, USO & USL divided by $WTIC which ideally should be a flat line, but is not. You can clearly see the rollover losses in OIL & USO

Here's my last try:
stockcharts.com/h-sc/u...
stockcharts.com/h-sc/u...
stockcharts.com/h-sc/u...

Mar 20 06:51 PM

[toobad41:]

Don't you think you should call it for what it is....gambling? Speculation? I can't believe anyone would call it investing! Futures are just that...gambling. Do you invest in Las Vegas as well?

Mar 21 09:47 AM

[storm999:]

Nice column. I didn't read the first column, however, this column details risks which is what I like to read. The most helpful thing to me is to see all the risks upfront, then the recommendation with its side order of reasoning.

Alternatively why not buy oil stocks? BP has a low PE and 8% yield. XOM is a little more pricey, there are dozens of stocks in this sector, which may pose less risk and pay a dividend.

Mar 21 10:23 AM

[ElGordo:]

If USO is pricing oil at $39 when oil is at $50 , this indicates to me one should buy USO.

Mar 21 11:28 AM

[petra:]

Good article and good posts, but there is one thing nobody seems to take into consideration. The oilprice is up about 20 $ or more than 60% and is more than likely to retest at least the 40 $ level.
For the next 2 or 3 months the only way to make money on oil is going short the USO.

Mar 21 02:07 PM

[EL Rider:]

Since Jan. 5, 2009 USO has lost $6.40 per share while spot crude oil futures are up nearly $4.00 per barrel. During that time USO was allowed to increase their float, did they do that?

USO appears to run by very unsophisticated traders or it is something worse. The fact that earlier this year they lost between $14-$20 per barrel rolling a position in a market that was under $50 per barrel during those rolls, while telegraphing their future moves to the market as a whole tells me that this is not something to be involved in. It appears that USO is making money outside of the oil markets in order to pay for the crappy job they have done trading their position.

The only reason I noticed USO is the terrible job they have done, I'm a futures trader who was pretty appalled at the fact that some "hot-shot" loser hedgey was throwing other people's $100 bills into the crude futures pit and at the storage facilities in Cushing every month during the roll.

Mar 23 10:55 AM

[Fairway Jack:]

I like the way you think. I am coincidently making many of the same trades you are. I also like GSG. No big time leverage but I like the weighting of commodities.


On Mar 20 12:04 PM SteadfastMason wrote:

> UOY does not seem to have much volume. That translates to me to be
> possibly tough to sell, if needed.
>
> I hold DXO, a 2X Oil Bull ETF and ERX. it is a 3x Bull, Energy ETF.
>
>
>
> SteadfastMason

Mar 23 11:42 AM

[AndrewNYC:]

Since the YTD low of February 18 to the close yesterday, USL is up about 31.5% vs about 38.25% for USO. If the spot price of oil goes lower, won't the contango come back and the problem with the negative roll yield for USO reappear? Personally, the risk of losing significant money on the roll doesn't seem worth the marginally better recent performance of USO. USL still looks like the better way to be long oil, if you believe that oil prices will rise at some point in the future but your expected time horizon for that is months as opposed to weeks. I think your original advice still stands, and I am still happier that I bought USL than USO and also happier to be holding it today.

Mar 25 12:37 PM