Why ETF UGA Outperforms USO: Getting Paid for Backwardation

Includes: BNO, UGA, USO
by: Richard Bloch

Jamin Chen’s first article on Seeking Alpha (welcome Jamin!) asked why UGA, the gasoline ETF seems to have diverged from the crude oil ETF USO.

I thought I’d chime in with some of my own observations on why UGA has outperformed USO for the past year or so. First, remember that UGA and USO do not represent physical commodity investments. Both funds own futures contracts. An investment in each mirrors what would happen if you bought the front month futures contract and kept rolling it out every month.

But what happens if you keep having to pay more every month to get that next month’s contract? Well, that puts a dent in your returns, but it’s not unexpected because most commodities have a contango – which represents carrying charges built into futures prices. However, when demand is really high, those carrying charges disappear – and you can buy next month’s contract for less than the current contract. That’s called backwardation.

Here’s a chart of the contango for both gasoline and crude oil over the past year.

The chart compares the percentage difference in contracts two, three and four months into the future against the current month contract. Note that crude oil contango does fluctuate, but that future month contracts always cost more during the timeframe. Gasoline, on the other hand, has been in backwardation at various times – mostly spring and summer – reflecting high demand and/or low supplies.

Costs of rolling out futures contracts

When you can sell your current futures contract and buy next month’s for less, your returns can be a lot higher. Consider a hypothetical trade: Going long gasoline and WTI crude oil contracts expiring in two months then rolling them over the next month. Here’s how those transactions would have looked like since July 2010 and closed as of May 26 2011:

The gasoline trade did well. The crude trade did okay too, but not by as much because the cost to roll the oil contracts out were a lot higher. Here’s a chart showing the cost of rolling out both gasoline and WTI crude oil contracts in percentage terms from the hypothetical trades above. The crude oil trade was fighting a contango headwind while the gasoline trade had the wind at its back, thanks to periods of backwardation.

So that’s one reason why UGA and USO have traded their separate ways, with UGA the clear outperformer.

The Brent difference

As far as USO is concerned, it may not even accurately represent the “real” oil market at all That’s because it’s based on West Texas Intermediate crude oil. But Brent crude has been trading at a significant premium to WTI almost all year, even though WTI is supposedly a superior form of oil. This WTI “discount” is a lot bigger than we’ve seen over the past six years.

Given this difference, what about comparing gasoline to Brent oil? Here’s a comparison of performance for the UGA gasoline fund against the BNO ETF, which tracks Brent crude oil – unlike USO which tracks WTI oil:

Quite a different story, isn't it? So keep an eye on that backwardation if you want to trade gasoline through UGA. If a significant contango returns, UGA may not be a good trade. And keep an eye on Brent for a more global view of crude oil trends.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.