Oil Market Contango Hurts USO

Tuesday, June 16, 2009

The United States Oil exchange-traded fund trades under the symbol USO and is the largest oil ETF by market capitalization and trading volume. Many investors in this ETF have been puzzled that the performance of their investment has failed to keep pace with the spot price of crude oil. The light sweet crude oil index is up 85% year-to-date while the USO boasts a relatively paltry 16% return.

The reason for this stark difference is based on the mechanics of the futures market. The USO, as stated in its prospectus, invests its capital in the front-month West Texas Intermediate crude oil contract. When the contracts expire, the fund rolls over into the next month's contract.

Often, futures markets will trade in contango or backwardation resulting in rollover gains or losses for long-term investors. In contango, the current month's contract converges with the lower spot price at maturity while the next month's contract is selling at a higher price because of higher price expectations by speculators. When the investor cashes out his current contract at the spot price, he is then forced to pay a premium to re-enter the market in the next month's contract. On the other hand, backwardation, which was much more prevalent when hedgers dominated the markets, results from the next month's contract trading at a discount to the spot price, or current month's expiration price.

These inefficiencies are unavoidable in their entirety but some actions can be taken. Better tracking ETFs, namely USL and DBO, invest in contracts further into the future or do a better job rolling over the contracts. Given the massive growth in ETFs of all shapes and sizes, investors need to be fully aware of the inefficiencies apparent in many ETFs that track underlying futures instruments. The SPDR Gold Shares (GLD) actually holds the physical commodity but holding crude oil is likely a much more difficult proposition. Often a dedicated trader may do much better trading the actual futures contracts rather than investing in ETFs.


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