Continuing the USO Tour

By Brian Baskin
Of DOW JONES NEWSWIRES
FEBRUARY 18, 2009, 3:04 P.M. ET
posted wsj.com

(USO hit its' all-time low today. -AM)

A tweak to the way United States Oil Fund LP (USO) manages its oil futures investment may not be enough to right the vehicle for ordinary investors to enter the market.

USO uses investments from shareholders to buy long positions, or bets that prices will rise, in the front-month oil futures contract on the New York Mercantile Exchange. An investor would need to pay tens of thousands of dollars to directly purchase a futures contract on the Nymex, but only $23.30 for a share of USO.

The fund, which started in 2006, has become so popular that as of Tuesday it held 19% of all Nymex crude contracts, and 30% of a similar contract on the ICE Futures Europe exchange, according to data from the fund and the exchanges. Traders say USO is big enough to cause a major shift in prices on the day each month that it "rolls" its position by selling out of the front-month and into the second-month contract.

But the oil market today barely resembles the world USO entered nearly three years ago. Oil prices were trading near a record high when USO debuted, and more than doubled over the next two years, lifting the fund's shares by 70% in the process.

Oil's 75% tumble since July has hurt USO, but the structure of the futures market itself is creating an even bigger problem for the fund and similar investors. On its latest roll, USO paid anywhere from a $4 to $6.10 premium to sell March and buy April futures contracts, as robust oil supplies and weak demand drove down near-term prices relative to outer months. USO's first roll likely carried a premium of between $1 and $1.50. Oil prices have fallen 3% over the last two months, but USO shares are down 28% over the same period.

Goldman Sachs Group Inc. (GS) analysts went so far as to call long-term holdings in front-month futures contracts "not investable" in a research note published Tuesday, citing the large roll cost.

USO will take four days to roll instead of one starting in March, according to a filing with the Securities and Exchange Commission. A longer period will allow USO to find enough counterparties to complete its roll, said a person familiar with the fund's operations. The fund will stick with holding front-month contracts, however.

"You can't go around changing the rules in the middle of the game," the person said. "USO was designed to be the front month, for good or for bad."

Market participants said a longer roll is likely to mitigate the massive one-day selloffs seen in recent months. These increased the cost to USO by exaggerating the gap between the front two futures contracts, and led some traders to blame the fund for distorting the market.

Others see USO as prisoner to an unprecedented set of market conditions. The global economic downturn is the most severe since the creation of the Nymex crude futures contract. Demand has fallen faster than supply, and the extra oil is piling up in storage. Usable tanks are nearly full at Cushing, Okla., the delivery point for the physical oil underpinning the Nymex contract.

As demand falls and tightening storage becomes more expensive, the value of holding oil today has dropped to an unprecedented low relative to outer-month futures contracts, a structure known as contango. When oil is in short supply, front-month crude trades at a premium, which would boost USO's returns.

USO's roll merely adds volume to a market structure that would have existed anyway, said Andy Lebow, senior vice president for energy at brokerage MF Global in New York.

"(USO) is a part of the market, and they definitely have exacerbated the roll, but I think the real problem is that you have to look at the fundamentals," Lebow said. "It's a fairly extraordinary situation - Cushing is full. Once Cushing starts to draw, they're going to have less of an impact."

Investors are starting to catch on. The United States 12 Month Oil Fund LP (USL), a USO sister fund that owns crude oil futures out one year, has seen its total assets more than double in the last two weeks. The gaps between futures contracts tend to narrow further out from the front month, reducing roll-day losses.

As for the USO, the economic problems driving the storage crunch are showing little sign of abating, which means shareholders may need to eat losses for several rolls to come.

"There is nothing they can do ... they are a victim of their own hype," said Stephen Schork, editor of the Schork Report, an energy newsletter. "As long as retail investors are dumb enough to buy into a contango ... we will continue to have this problem." (Ouch!-AM)