The United States Oil Fund (USO) is again causing controversy as angry investors accuse this ETF of not capturing crude oil's recent gains. The spot price of WTI crude is up 50% this year, while the USO - which is the most widely traded crude oil ETF - is up a paltry 16.5%.
Many investors assume that the USO simply tracks the price of crude oil. It does not. Rather, it invests in near-month crude oil futures. When those futures expire, the fund uses the proceeds to buy new contracts, a process known as rollover. When oil markets are in contango - that is future prices are higher than spot prices - rollover becomes a nightmare for the USO, forcing it to waste money selling oil and buying it back again at a higher price.
For instance, say the USO buys a 1 month contract at 50 dollars. One month later the contract comes due. If the fund took physical delivery of the oil, it could keep it for later and sell it at a time of its choice. If the fund were closed-ended, it could sell its contract and cash out.
But the USO isn't set up to store barrels of oil and is designed to be opened ended, so it must rollover. It sells the contract at the market spot price - say 51 dollars - and makes a 1 dollar profit. Next month's contract, however, is worth 55 dollars. So when the fund buys new futures to replace the old ones it loses 4 dollars. It will make most of that money back selling the new contacts later at a higher price, but so long as oil is in cantango it will never make all of it back as the following month's contract will be priced yet higher.
These monthly losses add up over time.
The oil market has been in contango all year, explaining why the USO has so drastically underperformed the spot crude oil price. Investors shouldn't blame the USO, however, as its investment strategy is clearly stated in its prospectus.
Rather, one should be aware that futures - which are inherently closed end instruments - are less than fully compatible with open-ended investment vehicles like ETFs. Funds that invset in futures are destined to poorly track the asset underneath.
Futures-based alternatives to the USO exist, but none of them solve the problems inherent in an open ended investment vehicle investing in a closed-end asset. The United States Oil 12 Month Fund (USL) mitigates the contango problem by buying contracts of different maturities, up to one year out.
The Powershares DB Oil Fund (DBO) does a similar thing, but both funds have still underperformed the spot crude price by a wide margin. Further complicating matters is that when contango reverses into backwardization, the funds' roles switch and the USO then outpaces the USL. Knowing which ETF to buy then means keeping close tabs on the futures markets, and accepting that your returns are not likely to correlate well with the price of the ultimate asset.
These shortcomings do not mean that all commodity ETFs are bad investments. Some futures ETFs in other markets have performed admirably, and even a 16% year to date return is hardly something to scoff at. And when futures markets are in backwardization, funds like the USO actually benefit. Further, ETFs like the SPDR Gold Trust (GLD) invest directly in the physical commodity, eliminating the contango problem. It is unlikely that regulators would approve of a fund that hoarded oil for investment purposes, however.
Which leaves an opening for a better way to play oil though ETFs. If you want an easy, transparent play on crude it would be better to simply invest in ETFs that track oil related equities. The equation here is much simpler. Rising crude oil prices mean strong earnings growth for companies involved in the extraction and sale of crude oil. Although commodities often outperform commodities producers, this isn't always the case. And the unavoidable problems faced by ETFs investing in commodity futures, makes commodity linked equities a safer bet. Three ETFs in particular make for good alternative investments to the USO and USL:
iShares Dow Jones U.S. Oil Equipment & Services Index (IEZ) +39% ytd
This fund invests in oil services and equipment companies like Schlumberger (SLB) and Halliburton (HAL) that derive their revenue from helping the oil majors exract oil more efficiently. Their expertise is especially needed in the harder to get oil made economical at higher crude prices. It's performed nicely ytd and is heavily traded.
iShares Dow Jones U.S. Oil & Gas Exploration & Production Index (IEO) +19% ytd
The IEO tracks an index of firms like Apache (APA) and Anadarko (APC) that specialize in finding and producing oil in new areas around the world. Such companies often do better than the majors when crude is high, and worse when the oil price falters. The fund has perfromed nicely - especially year over year - and has good volume.
SPDR S&P Internaional Energy Sector (IPW) +18.28 ytd
The IPW invests in a broad index of global oil majors like BP (BP) and Total (TOT). A decent performer ytd, it is the best performing oil ETF on a year over year basis, being down only 23% to the USO's 65%. It has poor volume, however.
These funds have seen better gains this year...
And fewer losses last year....
But rose less during the last contango-free boom...
As you can see the 2 year chart of the USO reveals that the fund has its charms. It's not accurate to claim that the USO is a scam, as some have. It simply does exactly what the prospectus says it does, even if its marketing isn't always entirely honest.
But overall, ETFs that track futures are more unreliable than those that track equities. Individual investors should leave commodity ETFs to the speculators and the professionals. And all investors should think about playing oil through a broad based equities exposure.
Disclosure: None
