Oil ETFs: Texas Tea or Empty Well?

On the front page of the Financial Times yesterday (sorry, I gave up reading the Wall Street Journal when it went mass market) the headline was “Oil at $60 for first time in six months.”

How wonderful! I was long oil using commodity ETFs/ETNs since December when the price was in the 30s. Thus I expected the price to be up 50-80%. This is where I hit the empty well.

Let’s start off with some price performance data, then explain how contango markets erode the price, and end with how we need to reexamine the usefulness of these tools.

Starting with the bottom of the market on February 19th, OIL, USO, and DBO closed at 15.55, 24.28, and 15.83. So, an 85% increase should get us around 28.75, 44.90, and 29.25. I know, for more sophisticated readers you will remind me about looking at the price in the paper. When you see the price in the WSJ or FT, they are usually quoting contracts for West Texas Intermediate (WTI) 30 days out.

But each of these three ETFs has its own special sauce to tempt investors on the ‘best’ way to invest in WTI. OIL is continually rolling over a portion of the portfolio to the nearest contract to supposedly stay close to the spot price of oil. USO claims to be buying contracts 30 days out so they should closely mirror the price for oil quoted in the paper! DBO has its own rule-based system described as “Optimum Yield Oil Excess Return.” Wow, sounds good to me! DBO further describes the strategy as “a rules-based index composed of futures contracts on Light Sweet Crude Oil (WTI) and is intended to reflect the performance of crude oil.”

I could give you the sales pitch that OIL and USO tell investors, but it is at about the same level of “very sophisticated and you wouldn’t really understand.” I even had a wholesaler from one of the funds (they should be glad I don’t mention which one) who in replying to my questions about how the mechanics work told me nobody ever asks those questions and I would have to talk directly to the portfolio manager. However, they did say the manager was very smart.

Let’s cut to the chase. Just get your charts out and compare the three ETFs since the February bottom. I can’t make this stuff up (to my dismay since I own OIL – and looking to sell as I type), and the percent gains are 38%, 34.4%, and 40.8%. This is a far cry from the 85% in the futures market. This makes me sick. While I am happy I picked the one that is up 38% (like it matters between the three?), I didn’t get anywhere near what OIL describes as an “index [that] is derived from the West Texas Intermediate (WTI) crude oil futures contracts traded on the New York Mercantile Exchange.”

Each fund tries to blame the other one for erosion of price due to contango markets; however, how good is this excuse if the performance on a huge 85% move leaves each fund with about the same return?

I am here to say today that these three devices do not work as described. Period. This is an incredible disappointment even though the ETFs have gone up over 30% in the last few months. Where is my 85%? In the past, I have suggested to readers to stick with one strategy so as not to get caught in the contango problem but now it seems like it doesn’t matter.

Going forward, I would rather take my chances on individual stocks that pay a dividend and are in the gas and oil industries. If BP is quoted in the paper at $47, I know the account will reflect this. So long guys, your well has gone dry.

Disclosure: Just sold my OIL position, long IEO and BP.

Comments

[seetch:]

Excellent observation. Except that if you actually consider the drop in oil as well, DBO actually performed quite well. In early Dec, Oil was trading at USD50 and it goes down to USD34 in Feb and then up to USD55 now. DBO went down the least and came up the least but at least they DBO is slightly higher than in early Dec. So if you had invested in DBO in early Dec, you would have recovered your gains...

May 14 07:48 AM

[Albert Meyer:]

>>"On the front page of the Financial Times yesterday (sorry, I gave up reading the Wall Street Journal when it went mass market)...<<<

Absolutely... I concur...

May 14 09:14 AM

[Lee Eugene ...:]

Albert,

I appreciate that feedback. Sometimes I think I am the only one! Recently I was at a CPA's office and I saw a copy of the WSJ and it said "Finally - Sports!". I felt vindicated. I can say that I am long News Corp since bastardizing the WSJ will insure the sheep will keep paying for it. . . .

Lee


On May 14 09:14 AM Albert Meyer wrote:

> >>"On the front page of the Financial Times yesterday (sorry, I gave
> up reading the Wall Street Journal when it went mass market)...
> <<<
>
> Absolutely... I concur...

May 14 09:48 AM

[Lee Eugene ...:]

Seetch,

Thanks for the info on this. I will follow up on it. However, I am done with these crappy tools. They are interesting to study.

Lee


On May 14 07:48 AM seetch wrote:

> Excellent observation. Except that if you actually consider the drop
> in oil as well, DBO actually performed quite well. In early Dec,
> Oil was trading at USD50 and it goes down to USD34 in Feb and then
> up to USD55 now. DBO went down the least and came up the least but
> at least they DBO is slightly higher than in early Dec. So if you
> had invested in DBO in early Dec, you would have recovered your gains...

May 14 09:49 AM

[Sailorman:]

I say the SEC neeeds to look into all these fancy EFT's and the manipulation of the facts and the markets. They are not what they are propsed to be.

The buyer needs to be more beware!

I own OIL and USO and SRS and am not happy with their performance!

May 14 11:05 AM

[AndrewBaker:]

Leaving aside leveraged ETF, which due to their construction are best for day and short-term trading, unleveraged ETF that aim to track an index be it commodity, stock or other, rarely match the index performance. The costs alone will tend to give underperformance against an uncosted index. Also, as mentioned above, contango eats into the returns where futures are bought and rolled over (although backwardation, being the opposite, works in the ETF holder's favour, and the reverse is true for short ETF).

My beef is that of bid-ask spread. So often the price that I think I will get goes against me at the time of buying. I feel that the software running these ETF quotes have a programmed in bias to cut out another itsy bitsy piece of the pie for the market-makers. Whilst two or three cents on a, say, $20 ask may not be much, it increases the costs, and also means that much higher must be obtained on the sale, which can also cut back against you on execution. Hey, they've got the spread anyway, why want more?

This has happened too often for it to be co-incidence or my imagination.

ETF are good instruments, so why do things to deter people from using them?

May 14 01:47 PM

[Kalani Martin:]

What you are failing to factor in is that the performance of these ETF's or ETN's compound daily. When comparing something that compounds performance daily to the performance of an index or the price of crude (WTI) over a period of time, there should always be significant differences. When you consider this, these products are working exactly as they are supposed to. It's basic math. The consistent contango we've seen doesn't help, but this daily compounding will also be a huge benefit when crude oil (WTI) is in backwardation.

May 14 08:23 PM

[isaac the t...:]

OIH is a good "oil" proxy, but you get to invest inreal companies, with good liquidity.

May 14 09:18 PM

[Victhom:]

OIL IS GOING BELOW $50.....BP up 40%:Profit taking on the way....!!!!

Oil slips to near $58 as signs of weak economies in US, Europe slow recent rally
Pablo Gorondi, Associated Press Writer
On Friday May 15, 2009, 6:44 am EDT
Buzz up! Print Oil prices slipped to near $58 a barrel Friday as signs of economic weakness in the U.S. and Europe led investors to consider whether this month's crude rally was justified.

Benchmark crude for June delivery was down 53 cents to $58.09 a barrel by midday in Europe in electronic trading on the New York Mercantile Exchange. On Thursday, the contract climbed 60 cents to settle at $58.62.

In London, Brent prices were down 49 cents to $58.10 a barrel on the ICE Futures exchange.

Oil recently rose above $60 a barrel on optimism that the worst of the U.S. recession was over, but dismal news this week on retail sales, unemployment and housing have traders reconsidering their outlook.

European data was likewise bleak as it showed the euro zone economy shrank by a massive 2.5 percent in the first quarter, with export-dependent Germany, the region's biggest economy, particularly badly hit.

"Some of the green shoots are looking like yellow weeds," said Christoffer Moltke-Leth, head of sales trading for Saxo Capital Markets in Singapore. "That's going to spill over into equity markets and have an effect on crude."

He projected that prices would fall back toward $50 a barrel soon, which could mean lower pump prices.

Investors got more evidence Thursday that global crude demand may be too weak to justify the recent run-up in prices. The Paris-based International Energy Agency cut its global oil consumption forecast for a ninth consecutive month and now expects demand to fall 3 percent in 2009, or about 2.6 million fewer barrels a day than last year.

May 15 11:37 AM

[bigmoney:]

I did some of the commodity ETF's last year, and discovered at tax time, they increased the complexity of my tax return with an annoying Schedule K-1, or something like that. It was time consuming getting the data into Turbotax.

May 15 11:29 PM

[Lee Eugene ...:]

I agree, we are long IEO and have traded OIH in the past and plan on sticking with them.


On May 14 09:18 PM isaac the terrible wrote:

> OIH is a good "oil" proxy, but you get to invest inreal companies,
> with good liquidity.

May 19 01:59 PM

[Lee Eugene ...:]

bigmoney,

Just think about multiplying that times all of my clients! Keeping clients CPA's happy is a real task when you give them late issued K-1's! Only certain MLP's are worth the hassle. I appreciate the comment.

Lee


On May 15 11:29 PM bigmoney wrote:

> I did some of the commodity ETF's last year, and discovered at tax
> time, they increased the complexity of my tax return with an annoying
> Schedule K-1, or something like that. It was time consuming getting
> the data into Turbotax.

May 19 02:01 PM

[Lee Eugene ...:]

Victhom,

Thanks for the comments. My firm has been taking parts of our BP position off the table recently. Trees do not grow to the sky!

Lee


On May 15 11:37 AM Victhom wrote:

> OIL IS GOING BELOW $50.....BP up 40%:Profit taking on the way....!!!!
>
>
> Oil slips to near $58 as signs of weak economies in US, Europe slow
> recent rally
> Pablo Gorondi, Associated Press Writer
> On Friday May 15, 2009, 6:44 am EDT
> Buzz up! Print Oil prices slipped to near $58 a barrel Friday as
> signs of economic weakness in the U.S. and Europe led investors to
> consider whether this month's crude rally was justified.
>
> Benchmark crude for June delivery was down 53 cents to $58.09 a barrel
> by midday in Europe in electronic trading on the New York Mercantile
> Exchange. On Thursday, the contract climbed 60 cents to settle at
> $58.62.
>
> In London, Brent prices were down 49 cents to $58.10 a barrel on
> the ICE Futures exchange.
>
> Oil recently rose above $60 a barrel on optimism that the worst of
> the U.S. recession was over, but dismal news this week on retail
> sales, unemployment and housing have traders reconsidering their
> outlook.
>
> European data was likewise bleak as it showed the euro zone economy
> shrank by a massive 2.5 percent in the first quarter, with export-dependent
> Germany, the region's biggest economy, particularly badly hit.<br/>
>
> "Some of the green shoots are looking like yellow weeds," said Christoffer
> Moltke-Leth, head of sales trading for Saxo Capital Markets in Singapore.
> "That's going to spill over into equity markets and have an effect
> on crude."
>
> He projected that prices would fall back toward $50 a barrel soon,
> which could mean lower pump prices.
>
> Investors got more evidence Thursday that global crude demand may
> be too weak to justify the recent run-up in prices. The Paris-based
> International Energy Agency cut its global oil consumption forecast
> for a ninth consecutive month and now expects demand to fall 3 percent
> in 2009, or about 2.6 million fewer barrels a day than last year.
>
>

May 19 02:02 PM