Alex McGuire: Many investors are looking to buy a crude oil index ETF to profit from oil’s rise throughout 2015.
WTI oil prices are up 7% this year. And we expect oil prices to continue climbing in 2015.
The expected oil price climb has made crude oil index ETF investing increasingly popular. TheWall Street Journal reported about $6 billion was invested in oil ETF sin the first quarter alone.
But many crude oil index ETFs have one major problem right now that many investors aren’t aware of…
Why You Shouldn’t Invest in a Crude Oil Index ETF
The problem is known as “contango.”
Contango happens when prices are higher than the spot price of oil.
You see, many of these oil ETFs track futures contracts rather than the spot price. When there’s a price gap between the price of the expiring contract, and the new futures contract, the fund has to buy contracts at the higher price. That means the fund is constantly buying high and selling low.
What Is Contango?
Contango refers to the situation when the oil futures contract trades at a higher price than the spot price of oil.
During periods of contango, people are willing to pay more for a commodity in the future than the actual expected price of the commodity. This can occur when people are willing to pay a premium for a commodity’s future delivery, rather than paying for the storage of the commodity.
This can be a problem for ETFs that track the price of oil using oil futures contracts.
When there’s a price gap between the price of the expiring contract and the new futures contract, the fund is consistently buying contracts at a higher price. Essentially, it’s constantly buying high and selling low on the futures contracts.
For example, if the new futures contract is $2 higher than the expiring one, investors will encounter what is called a “negative roll yield” of $2. Again, the ETF is buying high and selling low to track the price of oil month to month.
Contango typically occurs during periods of unusually low prices and high production.
The last time this happened to oil prices was the “supercontango” during the 2008 financial crisis. Back then, oil tanker ships stockpiled millions of barrels of crude oil off the coasts of the Gulf of Mexico, England, and other major production areas. The spread between spot prices and futures prices 12 months later was more than $23 a barrel for WTI.
Any spread between the spot price and futures price can cause crude oil index ETFs to miss profits.
This chart shows an example of contango at work…
The chart tracks price movements in the WTI spot price of oil compared to the U.S. Oil Fund LP (NYSE Arca: USO).
The United States Oil Fund is one of the most popular oil index ETFs on the market. Financial Times reported that more than $2 billion was invested in it in 2014.
But USO misses out on gains when the market is in contango. From 2009 to 2011, WTI prices increased more than 115% while USO only gained 34%.