When #crudeoil and USO are trending on Twitter, you know it's something more than just some 5% move or so; and it's about the exact same time we're getting calls from people asking the best way to invest in crude oil and the best way to profit from crude oil eventually rebounding. Chances are, you've already been profiting from crude oil's decline (we'll get to that in a second), so it might not make sense to bet on the other way, but we know better than that. We know there's those among us who see this down move into uncharted territory (the only time ever that crude has gone negative) and see the opportunity for a bounce higher.
Chart Courtesy: Charlie Bilello and Business Insider
Why is This a Big Deal?
Before you even have the thought of putting some skin in the game, it's nice to know you've likely already profited from this crude oil move without having to put up any cash. Airline prices are falling due to coronavirus (although, do you really want to go on a plane), gas prices are the lowest we've seen in years with some stations selling gas for $0.75/gallon, and lower prices on electricity, shipping, plastics, and more should eventually make their way to various products and services.
But whether it's Saudi princes or Russian tycoons, we're almost pre-programmed as modern humans to crave the type of over-the-top money that is "oil money." And without the millions to start drilling holes or bloodlines to be a prince - trying to time this bounce.
So, what's the best way to play a bounce in crude oil prices? Your friendly neighborhood ETFs? Most investors go the ETF route these days to bet on anything from real estate to bonds to global equities when trying to monetize an investment theme or idea. And the oil price ETF (USO) is one of the most popular ETFs out there.
What you Don't Know about the Oil ETF USO
It's the most popular way to play oil, to be sure, with $3.6 billion in assets and $736 million changing hands daily, but is USO really the best way to "play" a bounce?
Well, first remember what USO's stated goal is - to track the "daily" movement of oil. That doesn't sound so nefarious; aren't ETFs supposed to track the daily prices of the indices they track? Don't investors want to track the daily prices? Problem is - it's not as cut and dry as it seems. Tracking the daily prices is good if you are going to hold the ETF for one day, or even a couple of days; but can be not so good if your investment thesis is oil prices will climb higher over an extended period of time. Why? Well, here's where it gets tricky, because USO's long-term price appreciation isn't the same as the whole of all of its daily price appreciations.
That's because the ETF buys WTI Crude Oil futures contracts at the CME, and there are 12 different contracts in crude oil futures each year - you guessed it, one for every month. And while the so-called "front-month contract" is trading near the number you see on the news every night, the further-out contracts, such as 10-12 months from now, may already reflect the idea that oil prices will be higher, or in our most recent case, lower.
Indeed, the price for the December 2021 contract is $33.50, versus $15 for the front-month. So there's $18.50, or a 123% gain, already "built in" to the futures price. What does that mean for the ETF investor? Well, if you are correct that oil will rebound, and it does by around that 100% level, or $15 per barrel, over the next 19 months, the ETF likely won't appreciate 100% as well. It likely won't move at all, because it will have to sell out of its expiring futures positions and buy new (more expensive) futures positions each month (remember, there's a contract for every month). This means it will essentially have to "pay" that $15 over the course of the year in what's called "roll costs". The process of moving out of expiring futures contracts into current ones is called 'rolling' the contracts.
This is why USO had drastically underperformed the "spot price" of oil over the past 10 years (as of the end of 2019):
(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Barchart
Blue = USO Black = CLY00
So, the use of USO really comes down to when you think oil will be higher. If you think it's rocketing higher tomorrow, USO is a good choice. If you think it will be higher many months from now, USO is probably going to disappoint you by providing some discounted version of crude oil's actual gain (or worse - a loss when oil gains). Here's one of our favorite twitter follows Benn Eifert on the phenomenon:
So, what do you do if your friendly neighborhood ETF isn't the answer. You find some new friends... here are some more realistic, stretching it, and far-fetched ways to play a bounce in crude oil:
Realistic:
- Invest in a commodity-focused hedge fund manager featured in this profile like Jaguar Aegir, Cayler Capital, or Emil Van Essen Spread Trading Program for direct oil exposure.
- Buy long-dated crude oil futures (although the gain may already be reflected).
- Invest in an energy-heavy strategy like Amapa or Red Rock Commodity Long Short.
- Buy some long-dated "commodity currency" futures like the Russian ruble, Canadian dollar, and, to a lesser extent, the Australian dollar.
Stretching it:
- Take a flier on some MLPs at their deeply discounted prices - you have the yield.
- Buy the energy industry ETF, XLE. Just be aware that energy companies have a lot of things going on that don't relate to energy prices (debt, shareholders, employees, lawsuits, spilling oil, regulations), and don't use it to hedge against inflation instead of managed futures.(Want more? The 3x energy sector ETF, ERX, gives you three times the issues listed above).
- Get involved in the distressed debt of the energy sector companies that issued junk bonds like it was their job for the past few years. If you like sale prices, we're talking cents on the dollar here.
Far-fetched:
- Get into the game of buying tankers full of oil and sailing them around the world until prices go back up.
- Get involved in anything having to do with Brazil.
- Buy physical oil (a barrel, a tanker truck, whatever you're into). Just remember, that's why prices are falling to begin with - there's too much oil and not enough places to store it. You would now have the same storage problem. And it's not like you can go down to the local gas station and re-sell your barrel of oil.
Our Recommendation
Don't just buy and hold crude oil. It's known for violent swings, and whether storing it yourself or paying an embedded cost to own the investment, there's a high cost of carry. Instead, be dynamic. Invest in a strategy that can do well when crude oil rebounds, but also does well when it is in free fall. And can also do well when oil is doing nothing at all. Get exposure to energy prices, not exposed by them!
Disclaimer
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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
