Enhanced Oil Returns

By Brad Zigler

Pssst! Wanna make a few extra bucks off the oil market? Sure, you could have made handsome money being long crude oil this year. After all, NYMEX futures are up over 31% since the New Year's parties ended. The oil market's backwardation, though, offers a return kicker.

You remember backwardation, don't you? It's the state of the futures curve where nearby deliveries are priced higher than deferred contracts. Like today, when June NYMEX futures are trading at $126.05 a barrel while July crude changes hands at $125.85. We've dealt with backwardation and its opposite sibling, contango, in numerous articles, including "The Battle Against Contango." Suffice it to say that backwardation develops as a disincentive to store a commodity.

The oil market flips and flops from backwardation and contango like a hooked bluegill on the deck of a fishing boat. Oil inverted in July, after spending nearly two and a half years in contango. Despite the long stint in normalcy, the oil market seems to like walking backward. Since 1985, NYMEX futures have spent 57% of its trading days in inversion. Normal markets trended only 36% of the time and fibrillated for the remaining 7%.

So where's the extra money to be made? In the forward roll required to maintain index exposure. The United States Oil Fund (AMEX: USO) is your conventional - if such a term can be used here - oil index fund. USO buys and holds the nearby NYMEX futures ‘til it approaches the delivery period, then rolls the position forward to the next available month. Thus, the fund has the opportunity to capture today's 20-cent-per barrel positive roll yield.

USO's cousin, the United States 12-Month Oil Fund (AMEX: USL), however, is priced against the average of the nearest 12 delivery months of NYMEX crude oil futures (see "USL Oil ETF: The Early Innings"). That's goosed up roll returns lately. USL, since its December launch, has gained 42.2% versus USO's 41.1% return. USO's return enhancement annualizes to 3.8%, a not-too-shabby number, considering the 1.9% roll yield implied by the NYMEX term structure. Three-month T-bills are yielding 1.8%.

What's the trade-off? In this market, some extra volatility: USL's standard deviation is 31.5%; USO's is 30.1%. That still keeps the two funds' reward-to-risk ratios on par with one another at 3.9-to-1.

USO vs. USL

Comments

[smithoos:]

So where's the ETF Barclay's OIL? A year ago it was in the low 30s, now its in the low 70s. That's horse with some giddyap in it, seems to me. How come the author didn't discuss it?
Best,
Smithoos

2008 May 20 03:51 PM

[Managing Ed...:]

Because OIL isn't an ETF. It's an ETN.

The comparison between USO and USL--as both are ETFs--is direct. Thy're both subject to the same frictional costs. An ETN, as a structured debt instrument, isn't.

2008 May 25 05:15 PM