How Will Contango or Backwardation Affect United States Oil Fund?

By Brad Zigler

We've written plenty about the effect of contango and backwardation on commodity index returns on this site.

(See, for example, "The Battle Against Contango," and "Contango? Backwardation? Try Both.".)

No market better demonstrates the powerful impact of the futures pricing curve than crude oil. As supply concerns ebb and flow, the oil market rocks from full carry to inversion like a dinghy in the surf.

A long period of contango (deferred deliveries priced higher than nearbys) in crude left investors in commodity ETFs and ETNs scratching their heads wondering if they'd been sold a bill of goods by the portfolio manufacturers. Even though commodity prices, most especially crude oil prices, were rising, commodity index returns were paltry. Simply put, the cost of rolling futures forward - mandated by index rules - was eating index investors' lunch in a carrying charge market.

Index providers went to work to devise new benchmarks that would minimize contango's effect. And, wouldn't you know it? By the time these new products were cleared for trading, contango - at least in the crude market - was gone.

Crude's now in backwardation, and just last week, the United States 12-Month Oil Fund (USL) was brought to market. USL's price is based upon the average of the first 12 delivery months of NYMEX crude out on the futures curve.

With only a few days of trading under its belt, it's too early to gauge USL's effectiveness. But we can take a look at how the other oil portfolios have fared since crude's rotation from contango to backwardation.

Exchange-Traded Oil Portfolio Performance

Since 11 June 2007

	Standard Deviation	6-Month Return	Reward-to-Risk
West Texas Intermediate Spot (WTI)	27.99%	36.69%	1.35
MacroShares Up (UCR) Market Price	22.07%	10.51%	0.48
MacroShares Up (UCR) NAV	27.07%	36.15%	1.34
United States Oil Fund (USO) Market Price	26.99%	40.97%	1.52
iPath S&P/GSCI Crude Oil (OIL) Market Price	27.03%	41.42%	1.53
MacroShares Down (DCR) Market Price	33.36%	-16.15%	-0.48
MacroShares Down (DCR) NAV	74.07%	-44.64	-0.60

The performance of the United States Oil Fund (USO) and the iPath exchange-traded note (OIL) both reflect the positive roll yield that's been available since the summer. On an annualized basis, these portfolios could snare an additional 11.4% and 12.7% return, respectively, if conditions persist. No small change that.

One shouldn't count on contango or backwardation being a factor for the MacroShares oil portfolios (UCR, the "up" side and DCR, the "down" side), since their returns are determined by spot prices rather than futures. (For a discussion on MacroShares, see "Holy Macro!".)

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Comments

[gammaman]

Enter your comment hereThe concept of backwardation and contango have been simplified in relation to something called the "term structure of the futures price curve." Keynes et al. original concept of "normal backwardation" is based on the relationship of the futures contract to the "expected future spot price." This is a much more difficult concept for most to grasp and so is ignored because it doesn't "market" well. This paper:

"Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures"

raises the spector of something called "roll yield permutations." The paper is available on SSRN's eLibaray at:

papers.ssrn.com/abstra...