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How To Profit From Backwardation

|Includes:The United States Oil ETF, LP (USO), XOM, XOP
Earlier this year, I wrote about contango, the commodities market situation where longer-dated futures contracts are trading above the current spot price. This can happen with any commodity under the sun, but in most cases, I'd bet that investors know a little something about contango as it pertains to energy commodities, such as crude oil and natural gas.

As I mentioned in that piece, there is a reverse of contango known as backwardation. Backwardation is when current prices of a commodity trade higher than longer-dated contracts. I bring this up because West Texas Intermediate futures have moved into backwardation for the first time in roughly three years. Personally, I'm not celebrating nor degrading the fact that WTI has moved into backwardation if for no other reason than the spread between WTI and Brent Crude is still wide and the latter is really the global standard. Personal feelings aside...

If you happened to recently purchase the controversial U.S. Oil Fund (NYSE: USO), congrats. That was a shrewd move because USO has been rocked by contango in recent years, leading to steep losses even while WTI prices have surged. As long as backwardation is around, USO will be in the spotlight, and for positive reasons for once, because the ETF sells the front month contracts to purchase longer-dated contracts. Now that that's a profitable endeavor, USO investors should finally be pleased after several years of suffering.

Long story short, USO is one option for profiting from backwardation. I still like oil equities and the ETFs that track them. That statement may seem bold, almost brazen assuming that what the commodities market is telling us today proves accurate and that is crude prices will be lower in several months than the roughly $90 per barrel for which oil goes for today.

My logic is pretty simple economics and we've actually seen it at play this year. When oil prices are in the $110-$120 per barrel area, that's when consumers say “Enough is enough.” In other words, it may seem like a good idea to own shares of Exxon Mobil (NYSE: XOM) or the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) when oil is $120 a barrel, but it's not all it's cracked up to be.

Alright, so I've outlined the theoretical line in the sand where oil consumers halt consumption, but there is price area where producers and consumers are comfortable, sort of. That is the $85-$95 per barrel neighborhood. Faced with the specter of $120 oil, oil consumers are inclined to view $90 a barrel as a decent deal and faced with consumption decreases at $120, producers don't mind selling for $85, $89, whatever because those prices are still quite high by historical standards.

That's today's economics lessons. Today's profit opportunity for backwardation is equity-based ETFs. There's no shortage of oil sector ETFs out there, but I prefer XOP and I certainly prefer XOP to USO.

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Not only does XOP have a reasonable expense ratio, it's home to a few potential takeover targets AND the oil names conservative investors usually like. Not to mention, XOP is a great unleveraged ETF for active traders. Oh yeah, XOP has been on a roll lately and that was before the backwardation situation came about. See, you can profit with or without backwardation.

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Stocks: USO, XOM, XOP