Oil ETFs and ETNs: More Complicated Than You Think

Includes: DOY, OIL, UOY, USO
by: Gary Lucido

There are at least three main ETFs that allow the retail investor to buy oil, as in the commodity:

  • The United States Oil Fund (NYSEARCA:USO)
  • The iPath S&P GSCI Crude Oil Total Return Index ETN (NYSEARCA:OIL)
  • The MacroShares $100 Oil Up Fund (UOY)

The first two of these essentially buy oil futures contracts, while the latter one essentially represents an economic interest in 1/4 of a barrel of oil. Like its predecessor fund, UOY shares are created as one half of a pair of shares. The other half is the DOY shares, where the D stands for Down. There is a trust structure that basically obligates the UOY shareholders to transfer assets to the DOY shareholders to the extent that the price of oil moves down and vice versa. In other words the UOY and DOY shareholders are always on opposite sides of changes in the price of oil. Whereas the other ETFs derive their value from holdings of futures contracts the UOY/DOY pair derive their value from each other.

The difference in these ETFs has significant implications for the way these funds track the price of oil and this has resulted in some confusion. For instance, as of right now the oil futures market is in a significant state of contango with the March '09 contract settling today at 42.13 while the March '10 contract settled at 56.85. In other words, the futures market expects oil prices to rise by more than $14 per barrel over the next year. However, some have erroneously suggested that investors can profit from this expected increase by buying USO or OIL. If only life were that simple!

The fact of the matter is that if spot oil prices exactly followed the prediction of the futures markets over the next year, then USO would have exactly zero appreciation in that time frame. How is that possible?

Well, USO always owns the front month futures contract and therefore must always roll those contracts over as they near expiration. If spot oil prices exactly follow the futures price curve, then futures contract prices will never change and USO will never profit or lose as they roll over their contracts month after month. In fact, the only way for USO to profit is if oil prices rise by more than what is predicted by the futures market. In other words, USO will only profit if their futures contracts go up in value and that will occur only if oil prices outperform the futures price curve. So you might be correct that oil prices are going up over the next year and still not make any money investing in USO unless oil prices go up by more than $14 per barrel. The first $14 is already baked into the futures market.

So what about UOY? Well, that's a bit of a different story but no less complicated. While UOY doesn't own futures contracts, it does use the front month contract to set the reference price for determining the NAV each night. At some point during the month (usually the 11th business day), UOY switches its reference price to the next month's contract. At that point, if the market is in a state of contango, like it is now, the NAV is going to jump up. So the shareholders of UOY will benefit from the price increase, correct? If only life were that simple!

In reality, everyone knows that the oil market is in a state of contango and UOY's NAV is going to rise over time so that's already baked into the price of UOY. In fact, UOY has been trading at a substantial premium to NAV for quite some time (and DOY has been trading at an equal discount in dollar terms). As of Tuesday night it was at a 40% premium and that premium has been as high as 73%, or more than $23 per barrel. So you are pretty close to being in the same situation that you would be with USO - the only way to profit from UOY is if oil prices rise by more than what the market expects.

There is another investment strategy here. Personally, I'm betting that the contango is going to go down. Consequently, I've purchased USO and offset it with DOY. If the contango goes down the discount on DOY should go down with it and I will profit. However, given the subtleties in these instruments, the outcome of this trade is far from certain.

Disclosure: Long USO and DOY

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