Monday, February 9, 2009

The Tale of USO, USL and Contango.

Investors have been piling into the USO ETF expecting to profit from a future increase in oil prices. However, would you invest in a financial-derivative instrument that declines when the underlying remains constant?

Because of contango (further out oil contracts being more expensive than near term contracts) that is exactly what has been happening with USL in the recent months. USO invests in near term contracts, currently $40.72 for March contracts. In one month, USO will be forced to switch to April contracts, which are more expensive and now trade around $46.66. Thus USO, will hold fewer equivalent barrels of oil. If the price of oil remains constant, a month later, USO will be worth 12.7% less (=$40.72/$46.66), just before it moves to May contracts, and the whole process repeats itself, holding fewer and fewer equivalent barrels of oil.

Here are the current prices as per Nymex:

A better investment is USL, which spreads its investments into 12 months of future contracts. USL will still suffer from the contango effect though, with higher losses in the front-end months (where USO takes its big hit), and smaller losses in the back-end months. Below are some comparisons between the two.

5 days USL vs USO comparison:

1 month comparison:

3 months:

6 months:


Clearly USL has performed better than USO in all timeframes, but it will also be affected by contango. If the price of 0il will remain constant, you should really invest in neither of them. This is another case of buyer-beware.

About USO: The USO, United States Oil Fund, is a domestic exchange traded security designed to track the movements of light, sweet crude oil (West Texas Intermediate). "USO issues units that may be purchased and sold on the New York Stock Exchange (NYSE) Arca. The Company invests in futures contracts for light, sweet crude oil and other types of crude oil, heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the New York Mercantile Exchange (NYMEX), International Currency Exchange (ICE) Futures or other United States and foreign exchanges (collectively, Oil Futures Contracts)"

About USL: The USL, United States 12 Month Oil Fund, LP (US12OF) is an exchange traded security that is designed to track the movements of West Texas Intermediate light, sweet crude oil (WTI). "USL issues units that may be purchased and sold on the New York Stock Exchange (NYSE) Arca. The investment objective of US12OF is to have the changes in percentage terms of the units net asset value reflect the changes in percentage terms of the price of light, sweet crude oil delivered to Cushing, Oklahoma".

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WilliamH said...

Thank you very much for this post. It is most elucidating. I have learned a lot about these ETFs now.

Jive Dadson said...

Right after this article came out, USL started losing significantly compared to USO. Is it because the oil futures curve is flattening? I thought I understood this, but I thought wrong.

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