MacroShares Oil Funds Offer Arbitrage Opportunity

Includes: OIL, USO
by: Gary Lucido

Oil is trading around $98/barrel as of Thursday. So if I told you that you could buy it or sell it at $78.30 on Thursday which would you do? The answer seems pretty obvious doesn't it? So then why is it that some investors are paying full market price for oil while others are selling it below market? It reminds me of the Kathy Griffin video where she is trying to give away money and people won't take it. I've been perplexed for the last 3 months and I am no closer to understanding why this is happening other than that people are just naive.

Take a look at three of the main ways to bet on oil prices going up or down. There are the plain vanilla United States Oil Fund (NYSEARCA:USO) and the mouthful which is the iPath S&P GSCI Crude Oil Total Return Index Exchange Traded Notes (NYSEARCA:OIL) that pretty much use futures contracts to track the percentage change in the price of oil. These basically trade at NAV. Invest $1000 in one of these funds and you essentially have bought $1000 worth of oil.

But things get real interesting with the Macroshares oil up shares (UCR) and the Macroshares oil down shares (DCR) which are designed to track equal and opposite dollar changes in the price of 1/3 of a barrel of oil. The UCR shares have an NAV equal to 1/3 of a barrel or $32.80 but amazingly they were trading on Thursday for $26.10, which is a discount of over $20/barrel. Meanwhile, the DCR shares have an NAV equal to 1/3 of the difference between $120 and the price of a barrel of oil - i.e. when oil prices move down the DCR shares move up. On Thursday the DCR shares had a NAV of $7.28 but were trading at $14.19, which is a premium of over $20/barrel.

If you're interested you can read more details about the oil arbitrage opportunity that this creates and why it almost certainly will pay off at some point (especially if oil goes above $111 for three days in a row) but for now we'll keep this really simple. If you want to be long oil you should not buy USO or OIL. Instead you should buy UCR, which is at a discount. When the discount goes away you will get pick up an extra $20 per barrel. And if you want to be short oil you should absolutely not under any circumstances buy DCR. If you do you will be effectively shorting oil at $78.30 per barrel, which means it needs to drop $20 per barrel just for you to break even. You would be far better off shorting USO or OIL - which is admittedly not always easy but I have managed to do it.

On a somewhat unrelated note...

There also seems to be a bit of confusion over a few aspects of these Macroshares that I thought I would attempt to clear up. First, people obsess over the percent premium and discount - which is really meaningless for these shares since they track the dollar change in oil prices and since the DCR shares keep getting lower and lower as oil prices rise. Given the structure of the funds it makes a lot more sense to focus on the discount and premium per barrel of oil.

Second, some people have claimed there is a flaw in the way the funds are invested, since they don't really own any oil related securities. However, given their structure they don't need to invest in oil. The two funds simply pass their gains and losses back and forth to each other. It's actually quite a clever idea.

Third, the fund is not broken or toxic, nor has Dr. Shiller (the architect of the funds) made a mistake. The real problem lies with investors who are willing to take a bad deal.

Disclosure: Long UCR