Search This Blog

Monday, April 29, 2013

Why USO Hasn't Tracked Oil Prices

One of the problems with the USO Oil ETF is that it doesn't track the underlying price of oil very well. In fact, the USO ETF (“United States Oil”) closed today at 33.12 while the price of June West Texas Intermediate Crude closed at 94.50 — that's a whopping difference for an ETF which is supposed to track the commodity! The problem with USO, which we've pointed out on various occasions is that the fund has to buy oil one month and, after holding it for a month, roll it the next month, at a loss of premium if the next month is trading at a higher price. These losses mount up over time when the commodity is in a state known as “contango”—which simply means that more distant in time contracts trade at a premium to nearby contracts. The opposite situation—“backwardation”—occurs when more distant contracts trade at a discount to nearer-term contracts. During times of backwardation, the buy-and-hold investor collects a premium bonus every time they roll (sell the expiring contract and purchase the next one) to the next contract. That can amount to quite a bit of premium over time.

One interesting thing about bull markets in commodities is that backwardation is often a sign of a bull trend. It isn't necessary that a commodity be in backwardation to be a bull market, but it is a confirming indicator that a bull market is underway. So, it's no wonder oil has not been in backwardation in many years—it has indeed been in a bear market.

Interestingly, there is a market in oil which is in backwardation, but it's the European Brent Oil contract rather than the United States Oil contract. And there is an ETF which tracks the Brent contract. Its ticker is BNO and it has performed well since the Brent contract went into backwardation. Here's a chart comparing the two ETFs courtesy Yahoo! Finance::

The big difference in the performance of the two ETFs appears to be mainly due to the backwardation in the Brent contract and the contango in the US contract. This suggests that if the US contract were to go into backwardation, the USO would start to close the gap between it and BNO. Alternately, the Brent contract could go into contango, which would eliminate its advantage. If we do get a general commodity bull market going, this is an important point to consider in choosing an ETF route to play the bull market in oil. If one of the underlying contracts is in contango and the other is in backwardation, choose the one in backwardation for long term holding periods. Since the rollover occurs just once per month in each contract, unless you hold the ETF across the monthly rollover date, the performance of the ETF shouldn't be affected by this factor.