Wednesday, February 18, 2009

Oil's well that ends well

(As previously posted here a) suspect that the next boom will be in commodities and b) since the most liquid oil ETF, USO, has had to rollover into future near contracts that are priced much higher -contango- the NAV is decreasing disproportionately to the underlying price.

One would think this would present an opportunity if, as per my greedy expectations oil, as well as other commodities, go into backwardization before we hit the true bottom in this cycle. The examination below is indicating that given the size of USO, the ETF is actually exacerbating the contango.

If that is the case one might suppose that were folks to capitulate and run for the exits on USO at some point then there may be a small window where USO has to dump near and next month contracts - per the stated revision below- which might, perhaps, exacerbate backwardization.

Just sayin' - AM

Posted by Izabella Kaminska on Feb 18 13:46.
FT Alphaville

Olivier Jakob at Petromatrix has commendably taken a strong stance against the USO ETF fund over the last few weeks, or rather, exposed to what degree the fund’s market inexperience is causing all sorts of mayhem for the WTI contract. All of this, he says, is because the fund has now achieved ‘’critical mass’.

Unsurprisingly, his Wednesday note shows a similarly strong view:
Despite the flat price weakness on crude oil, the contango on the expiring spread continues to narrow, in a pattern very similar to the previous expiry. The convergence of the expiring contract is now being done pre-expiry on a narrowing of the spread rather than post-expiry on a flat price basis. This re-enforces our view that the extreme contango on the WTI contract is primarily due to market distortions created by the USO WTI ETF. This cancer to the oil markets is however not yet over as positions in the USO were increased further yesterday and now reach 93′000 WTI April Futures contract.

Petromatrix: in our weekly note of Feb 9th we advised that passive investors ought to be overweight oil equities/underweight the WTI ETF. Goldman Sachs has put out this week a research note advising clients to be overweight commodity equities/underweight the commodity, but they are not yet mentioning the distortions created by the ETF on the WTI markets. In a separate note, Goldman has advised taking profit on the short flat price at the back of the curve and turning instead to buying the long dated spreads Dec9/Dec11.

Jakob certainly has a point. What’s more, it is becoming increasingly obvious that investors in the fund are really confused on the matter of contango and how it affects them. The point they need to understand is that oil is not cheap even at these levels if they are holding the position long-term and losing successively on the rolls.

The fund’s performance shows a 22 per cent decline in the month of December. Crude fell in December but not quite as much as that. Of course it’s got worse. Yesterday alone the fund was down 8.3 per cent, while WTI itself was down 6.88 per cent.

But it seems the USO may have finally seen the folly of its ways. A rummage through the SEC filings shows up this discreet release on February 13th, which as yet has not been issued on the fund’s website.

Since inception, the futures contract for light, sweet crude oil traded on the New York Mercantile Exchange (the “Benchmark Oil Futures Contract”) of the United States Oil Fund, LP (”USOF”) has changed from the near month contract to expire to the next month contract to expire, starting on the date two weeks prior to the expiration of the near month contract. The change in the Benchmark Oil Futures Contract occurred in its entirety from one day until the next day.

Effective for contract months commencing after March 2009, the Benchmark Oil Futures Contract will be changed from the near month contract to the next month contract over a four-day period. Each month, the Benchmark Oil Futures Contract will change starting at the end of the day on the date two weeks prior to expiration of the near month contract for that month. During the first three days of the period, the applicable value of the Benchmark Oil Futures Contract will be based on a combination of the near month contract and the next month contract as follows: (1) day 1 will consist of 75% of the then near month contract’s total return for the day, plus 25% of the total return for the day of the next month contract, (2) day 2 will consist of 50% of the then near month contract’s total return for the day, plus 50% of the total return for the day of the next month contract, and (3) day 3 will consist of 25% of the then near month contract’s total return for the day, plus 75% of the total return for the day of the next month contract.

On day 4, the Benchmark Oil Futures Contract will be the next month contract to expire at that time and that contract will remain the Benchmark Oil Futures Contract until the beginning of following month’s change in the Benchmark Oil Futures Contract over a four-day period. On each day during the four-day period, United States Commodity Funds LLC, the General Partner of USOF, anticipates it will “roll” USOF’s positions in oil investments by closing, or selling, a percentage of USOF’s positions in oil interests and reinvesting the proceeds from closing those positions in new oil interests that reflect the change in the Benchmark Oil Futures Contract. The anticipated dates that the monthly four-day roll period will commence for 2009 will be posted on USOF’s website at, and are subject to change without notice.

Of course, as Olivier Jakob tells FT Alphaville, that still doesn’t solve the problem of clashing — and hence competing heavily — with the GSCI index on the liquidity roll.

(If backwardization does occur it would seem that USO would be the best vehicle to exploit such a curve even given the change cited.

In comparison other oil ETFs won't perform as well as USO in backwardization... -A

USL: The total return of a portfolio that owned the near month contract and ‘‘rolled’’ forward each month by selling the near month contract as it approached expiration and purchasing the next month to expire would be positively impacted by a backwardation market, and negatively impacted by a contango market. Depending on the exact price relationship of the different month’s prices, portfolio expenses, and the overall movement of crude oil prices, the impact of backwardation and contango could have a major impact on the total return of such a portfolio over time. The General Partner believes that based on historical evidence a portfolio that held futures contracts with a range of expiration dates spread out over a 12 month period of time would typically be impacted less by the positive effect of backwardation and the negative effect of contango compared to a portfolio that held contracts of a single near month. As a result, absent the impact of any other factors, a portfolio of 12 different monthly contracts would tend to have a lower total return than a near month only portfolio in a backwardation market and a higher total return in a contango market.

DBO :The Deutsche Bank Liquid Commodities Indices Optimum Yield (DBLCI-OY) employs a rule based approach when it 'rolls' from one futures contract to another for each commodity in the index. Rather than select the new future based on a predefined schedule (e.g. monthly) the index rolls to that future (from the list of tradable futures which expire in the next thirteen months) which generates the maximum implied roll yield. The index aims to maximize the potential roll benefits in backwardated markets and minimize the loss from rolling down the curve in contago markets.

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