by Michael Hampton, AKA Dr.Bubb
January 15, 2009
Many investors share a common misconception about how rewarding an investment the Oil ETFs will be in a bull market for oil. Here's a recent discussion we had on GEI, my investor forum. I think it illustrates the common lack of understanding about the oil ETFs actually work.
Many people are going to be disappointed if they fail to understand the impact of the present super contango upon future investment returns of these instruments. Here's a lightly-edited version of a discussion that took place in the last few days:
Al: I am bullish on oil at under $40, and have been looking to buy the dip soon. I think there's alot of money to be made on Oil's rise, if we see it, by late 2009.
Bob: How do you go long oil at $40? Have you got a tanker to store it in?
Al: I am talking about using one of the many oil ETFs that are available.
Bob: You cannot truly "buy oil at $40" that way. You merely buy an ETF whose price "relates" to Oil.
Here's yesterday's Oil Futures Curve:
Feb.09 : $40.83
Jan.10 : $59.48
What sort of profit do you expect if oil hits $59.48 in Dec. (using the Jan10 contract as your price measure)?
Al: For simplicity I am going to change those prices to $40 & $60, the difference between them is 50%. So I might make 50%. Or using a 2x leveraged ETF that should be approaching 100%. Based upon your real figures (for current futures prices) I would reckon at least 90%.
Bob:Sorry - but that's not true. Chances are: You will breakeven or lose money with USO, or one of the other oil ETFs.
Here's why...USO (to pick on the highest volume Oil ETF) does not own any physical crude oil, it merely buys futures contracts...(The prices I have quoted above ARE THE CURRENT PRICES for WTI (as of January 10, 2009) USO uses those contracts to hedge itself - and, since it must rolls its positions forward on a regular basis to prevent taking physical delivery, it is not easy to consistently do better than achieve the market prices.
Think of it as climbing a ladder. As each month goes by, USO sells one month's contract, and buys the next month forward. In the current market with its steep contango. there's a big premium to "roll forward" into the next available month. In other words, the space between the rungs is big, and it must pay up, to get onto the next month forward. In practice, management has some leeway, and they do not have to wait for the last days, or even the last month, to roll forward. But roll forward, they must, since they are not set up to take physical delivery.
Think about the impact this "rolling forward" behavior has upon USO's Net Asset Value. Since USO has limited funds, when the the forward rungs in the price ladder are higher, it is going to have to buy only a smaller number of barrels each time that it rolls. So it might Buy March (at $46.07) and Sell Feb. (at $40.83)*. It is paying 12.8% more per barrel to roll, and so it will wind up owning 13% less oil, and there will be 13% less barrels backing each share of USO. This is why USO now trades at $32.37 per share, versus $40.83 per barrel for WTI. When it started, there was one barrel backing each share in USO. Now each USO share is backed by 0.703 barrels (using March's WTI price.) In addition, something that I am not factoring into these calculations is the cost of the transactions (small) and the administrative cost of running USO (not small.) That is why I say that you might even lose money with USO if the oil future curve stayed as it is now.
In an upwardly sloping "contango" market such as we have at present, the "barrels per share" backing for USO diminishes, while in a downwardly sloping "backwardated" market, the number of barrels backing each share will increase over time. Thus, in markets like this, it is perhaps better to buy shares of companies with oil "in the ground" so they do not need to pay the high forward premiums (which tend to be related to storage costs.) Alternatively, to buy shares in companies whose valuation is historically associated with the oil price (like oil service stocks, and some other "oil-related stocks" that I am following.)
Do you see why I buy "oil related" securities, rather than USO, the Oil ETF ?
WTI Futures Curve, "like a ladder"
Feb. 2009 $40.83
Mar. 2009 $46.07
Apr. 2009 $49.11
May 2009 $51.21
Jun. 2009 $52.75
Jul. 2009 $54.13
Aug 2009 $55.22
Sep 2009 $56.17
Oct 2009 $57.04
Nov 2009 $57.87
Dec 2009 $58.69
Jan 2010 $59.48