Tag Archives: MarketFolly

Debating the WSJ’s Assessment of USO

In a continuation of yesterday’s post, It Takes Two (Months) to Contango, I want to focus a little more on the roll. The roll is what an investor, or speculator, in the futures market needs to do to keep their investment open and avoid taking delivery of the commodity in question. Remember, futures are an obligation to buy or sell a commodity at a certain price on the day the contract expires. If you don’t close the futures contract before it expires, you can expect a big truck to unload 1,000 barrels of oil on your lawn in a few days. Unless you’re running an oil refinery, this is not a good move.

Before expiration, investors betting on a commodity need to sell the contract for next month and buy the contract for the second month out. When the first month expires, the second month contract, becomes the new first month contract. Yesterday’s post dealt with the cost involved with the roll and how when the price of oil is rising, a trend called “contango,” you will earn less than the total movement in the spot price of the commodity. However, unless you want to take delivery, this is the closest way to play the spot price.

Last week I highlighted an article in the Wall Street Journal. It said the U.S. Oil Fund (USO), the exchange-traded product that is a pure play on the first month oil futures contract, is getting so large it’s affecting the oil market. The Journal writer Carolyn Cui says the $3.3 billion in assets held by USO accounts for 22% of the outstanding front-month contracts. According to Cui the fund is so large that on the day it moved from the March to the April contract, Feb. 6, it had a visible affect on the oil market.

I called John Hyland, the portfolio manager of the U.S. Oil Fund, to get his take on this. Hyland says you can’t blame a huge one-day move solely on USO without looking at the trend three days before the roll and three days after.

“The people who look just at the day we roll and say the spread was “X”, that doesn’t tell you anything,” says Hyland. “You have to look at the days leading up to and the days after. You might miss the trend going on if you just look at USO.”

For instance, if the three days before the roll, the spread on the contract was $1 and the day of the roll the spread jumped to $2, then you can say there was an affect.

According to Hyland, the three days before Feb. 6, when USO rolled over its contract, the spread between the March and April contracts were $3.99, $3.87 and $3.88. The day USO rolled it jumped to $4.55. However, the next day the spread grew to $4.76 and over the next few days jumped to $4.81, $5.24 and $6.06, eventually widening to $8.19.

“The spread is tending to move wider as you get into the middle of the month, as March gets closer to expiration. Is that USO’s doing? How are we doing it after our roll?” asks Hyland. “It looks to me that as we get closer to expiration, it’s more of an inventory issue. The people who say it must be USO are not really looking at everything.”

Inventories are rising. If demand for oil drops off a million barrels a day and OPEC produces the same amount of oil, then inventory goes up million barrels a day. A lot of oil in the tanks is not bullish for the March contract. With supply rising and inventories hitting 52-week highs, one would expect the oil price to weaken. If OPEC cuts production, the shortfall will be made up from the current inventory. As inventories get smaller, the front month contract will stop trading at a big discount to the contracts further out.

People are assuming inventories will not build up indefinitely. OPEC will have to reduce production, if for no other reason than they will run out of storage tanks. Since the cheapest place to store oil is in the ground before you pump it out, they will cut production. At that time, inventories will start to shrink.

Market Folly, the blog posting I ragged on yesterday, actually has an interesting slide presentation from the International Energy Agency from November called The Era of Cheap Oil is Over. It’s a good read for anyone investing in oil.

It Takes Two (Months) to Contango

Caveat emptor.

It’s Latin for buyer beware. There’s no doubt that a lot of people in this world want to make money off of selling you junk. In fact, that’s a pretty good assessment of the entire collateral debt obligation market. If buyers had paid a little bit more attention to what they were buying, we might not be in the financial mess destroying the country.

ETF companies aren’t selling junk, but investors still need to be aware of what they’re buying. Many ETFs are extremely sophisticated instruments. Investors may think they are buying one thing, when in fact they are buying another. The problem isn’t with the ETFs. These transparent instruments lay it all out in the prospectus and usually in the easy-to-read fact sheet on their Web sites. The problem is investors need to do their homework.

For example, Tradefast, an independent equity trader at a private investment fund, writes on the MarketFolly blog about how contango affects the crude oil ETFs. He says “three factors play a role in determining the performance of the United States Oil Fund (USO): 1) changes in the spot price of crude oil, 2) interest income on un-invested cash, and 3) the ‘roll yield’.”

Unlike the two gold ETFs, the StreetTracks Gold Trust (GLD) and iShares COMEX Gold Trust (IAU), which actually hold gold bullion, USO doesn’t hold the underlying commodity, barrels of oil. It owns oil futures contracts.

While the spot price of crude oil, the price it costs to buy a barrel of oil today for immediate delivery, may affect how investors buy or sell this exchange-traded vehicle, USO doesn’t track the spot price. It holds holds the front month futures contract, which is where oil traders expect the price of oil to sell for a month from now.

So, while the spot price will influence where investors expect the price of oil to be a month from now, they don’t necessarily move together. For example on Friday, anticipation that passage the economic stimulus package going through Congress would increase demand for oil, the price of the March crude futures contract for West Texas Intermediate crude oil jumped $3.53, or 10.4%, to $37.51 a barrel on the New York Mercantile Exchange. Meanwhile, the spot price closed Friday with a bid/ask spread of $37.60 to $37.65, according to the Australian Associated Press.

USO investors hoping to capture the spot market’s Friday gain were surprised to see the ETP actually fall 1.2%. That’s because the previous Friday the fund had rolled out of the March contract and bought the April contract to avoid taking delivery of the actual oil this Friday. So, while the March contract jumped 10%, the NYMEX April crude contract fell 0.47% to $41.97.

It’s the forward roll from the first month contract (March) to the second, and future first, month contract (April) that upsets MarketFolly. When the price of oil is rising, it’s in a trend called “contango”. This means that demand for oil in the future is greater than today, or that future supplies will be tighter. So, when you sell the first month contract, you have to pay up to buy the next month’s contract. It’s not a straight line up like in a stock. If you sell the March contract at $37.50 and buy the April at $41.97, you have to pay an additional $4.47 per contract. This additional cost eats into returns. Well, with a little bit of research, such as reading this story I wrote for SmartMoney.com when USO launched three years ago, he wouldn’t have been so surprised.

MarketFolly then realizes that “USO is not a direct play on the spot price of crude oil – it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (the slop of the futures curve).”

Because of this he says that USO is not a good way for investors to play the price of oil. For some reason, the FT Alphaville blog from the Financial Times agrees with this ridiculous assertion. Since investors can’t buy the spot price of oil without taking delivery, you have to buy futures to make any kind of play on the price of oil. So, all investors pay the roll, not just USO. If investors were buying futures and not the ETP they would have to make the same kind of trades USO makes, pay the same cost of the forward roll, plus the transaction costs.

What Tradefast fails to realize is “being in contango doesn’t means you lose money,” says John Hyland, the portfolio manager of USO. “Being in contango means you underperform the spot price. If the price of oil rises $100 again, even in a contango market you still make money. You just make less that the return in spot, say $90. They just focused on one half of the equation.”

Hyland says in the reverse scenario, backwardation, when the price of oil in the second future month is lower than the near month contract, the investor would outperform the spot price, but that doesn’t mean you make money. “Spot can fall 50% and you fall 40%. So you outperformed the spot price, but you still lost money.”