Why USL Beats USO In The Battle Of Oil ETFs

| About: The United (USL)

Summary

The U.S. Oil ETF is by far the largest oil ETF in the marketplace, but right now, it isn't the best choice.

The U.S. 12-Month Oil ETF spreads its futures exposure over 12 months instead of one helping to limit portfolio costs due to trading.

The contango market in the oil futures market is destroying value at a faster pace in USO.

If contango flips to backwardation, USO likely becomes the better choice.

Trading more than 30 million shares a day, the United States Oil ETF (NYSEARCA:USO) is easily the most popular proxy for traders wishing to trade on oil prices. That doesn't necessarily mean that the fund does a good job of it. The price of a barrel of WTI crude oil is up nearly 17% year to date but the U.S. Oil ETF is down about 8%.

The high cost of futures contract trading along with contango in the oil futures market make this fund less than ideal for a holding period any longer than a few days.

The issues the fund has in closely tracking the price of oil, especially around the time that the monthly contracts roll over, can make any trade a potentially costly one. But there is an ETF that does a better job in tracking oil prices than the U.S. Oil ETF - the U.S. 12-Month Oil ETF (NYSEARCA:USL).

Background

For a quick tutorial on how the funds work, the U.S. Oil ETF purchases oil futures contracts for the most relevant delivery date, which in most cases is the following month. As the delivery date approaches, the fund liquidates its $3 billion position and reestablishes a position in the following month's contracts.

The contango state of the oil futures market makes a full monthly turnover of the entire fund's assets very costly. Since the cost of next month's contract is higher than the current month, the fund ends up selling at one price and buying at a higher price and does this every month. In this scenario, the fund ends up owning fewer and fewer contracts decaying the fund's value on a constant basis.

The U.S. 12-Month Oil ETF holds an advantage over the U.S. Oil ETF in a contango market because it only ends up turning over 1/12 of the portfolio every month. A large chunk of the cost that comes with contango ends up getting avoided.

USO vs. USL Performance

While the U.S. 12-Month Oil ETF has also trailed the price of oil by a large margin, it's done better than the U.S. Oil ETF.

WTI Crude Oil Spot Price Chart

WTI Crude Oil Spot Price data by YCharts

USL is outperforming USO by nearly 11% year to date. This is just a comparison of performance over the past nine months but the story remains the same going back five years and beyond.

However, the outperformance of USL shouldn't necessarily be counted on to continue. Which of the oil ETFs to choose is largely dependent on the state of the futures market. In a market where contracts further out into the future are more expensive, the 12-Month Oil ETF will likely come out ahead. If the opposite scenario begins to occur where future contracts are less expensive than current ones (known as backwardation), USL will likely trail USO. Contango can destroy the value of the portfolio but backwardation can help add to it.

Conclusion

A couple of things to remember here…

  1. As I mentioned at the top of this article, both USO and USL are really only appropriate for holding periods of a few days or less. Consider any other longer time period and you can easily see how both ETFs (or any fund that deals in futures contracts really) fall further and further behind the commodity they're looking to track.
  2. The cost of contango will be present in either of these funds. It's just a matter of degree. The most important factor in which oil ETF to choose, though, comes down to the oil futures curve. In the current market, where longer-term contracts are more expensive, USL is the choice. But, if the curve ends up flipping around at some point, then be prepared to swap out USL for USO if you want oil exposure.

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