Contango/Backwardation Shredding Up The Oil ETF (USO)
“I had read about the problems with US Oil Fund (USO) but it wasn’t until I plotted a simple graph comparing it to crude oil futures contract that I understood just how little badly it has performed,” Traders Narrative Reports.
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Traders Narrative continues to write “The chart shows the ratio of USL to the crude oil futures contract (West Texas intermediate) since the ETF’s founding on April 10th 2006. Here are the four variables that influence the difference in the performance of the (USO) ETF vs. the crude oil futures which they are supposed to mimic:”
- contango/backwardation
- MER (0.45%)
- rollover impact
- interest earned (on 90% of fund assets)
“The MER is too low to account for the enormous valuation drift. So too is the (positive) effect provided by the interest earned on the majority of the ETF’s assets. Right now interest is so low that we can assume these two cancel each other out. Therefore, the other two variables are the key. Contango occurs when later futures contract prices are more expensive than current contract prices. Backwardation is the opposite. We’ve been experiencing contango for about two years now. Right now the current NYMEX contract (November) is $70/barrel. Meanwhile the March 2010 is $72/barrel. This has meant that (USO) has had to buy slightly more expensive contracts every month, in effect, shaving a little off their asset valuation little by little,” Traders Narrative Reports.
“As well, due to the gigantic size of the fund, the impact of rollover exacerbates the already existing difference between expiring and forward month contracts. As USO sells their holdings, they push down prices and as they buy, their demand increases prices. Of course, other market participants can count on their rollover to front run their obligatory monthly cycle. All this means that the fund has done an abysmal job in tracking the crude oil market. From the start of the year until now, crude oil futures have gone up about 50%. But if you tried to replicate that by buying USO instead, you would have been out of luck as the ETF has gained less than 5% for the year,” Traders Narrative Reports.
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The investment (USO) seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil. The fund is nondiversified.
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I see retail investors getting eaten up daily bya lackof understanding in these etf’s and how they work. We are at the mercy of the market makers that run these funds and they have done a horrific job with USO lately.
Good work!