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Don't Buy USO (Buy USL Instead)

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February 25, 2009 – Comments (7) | RELATED TICKERS: USO , USL

Don't Buy USO (Buy USL Instead) IndexUniverse StaffMonday February 9, 2009, 10:59 am EST

I have nothing against people wanting to buy oil at $40/barrel. That's a cheap price, and there's reason to believe that spot crude may rise over the next six-to-twelve months. OPEC appears to be sticking by its production cuts, overall supply is down and it feels like the global economy may be leveling off. Oil could easily go to $50/barrel, which would be a 25% jump from here. Where else in today's market are you going to get that kind of return?

But if you want to profit from that rise, USO isn't the way to do it.

This is a big deal. According to the Wall Street Journal, investors poured $3.46 billion in new money into the U.S. Oil Fund (NYSE Arca:USO) in December and January. That makes my hair stand on end, because those investors have gotten crushed. And if things stay the way they are today, they're going to continue to get crushed.

The reason, as I've written about time and time again, is contango. The oil market is in violent contango right now. All else being equal, any strategy that focuses on buying the front-month futures contract and rolling it forward is going to lose money. A lot of money.

This is simple mathematics, and it pains me that people are missing the story.

Here are the current prices for oil contracts with expirations in the next six months. Notice how every contract is more expensive than the one that preceded it. USO follows a simple strategy of buying the current contract and then rolling into the next contract before the current one expires.

March 2009 $40.42 April 2009 $46.22 May 2009 $48.88 June 2009 $50.45 July 2009 $51.28 August 2009 $52.70 Source:NYMEX. Data as of 2/9/08. Until last Friday, USO owned the March 2009 contract. Specifically, it owned 84,378 March contracts, entitling it to 84.4 million barrels of oil.

But on Friday, it sold all those contracts and bought the April contract instead. But because the April contract cost $6/barrel more than the March contract, it couldn't afford as many contracts. In fact, if you exclude new inflows into the fund, it could only buy 73,444 April contracts.

Whammo presto, the holders of USO lost 13.4% of their exposure to crude oil. They now control less oil. If the spot price stays near $40/barrel, the value of those April contracts will decay back to $40/barrel over the next month and investors will lose their shirts. If the price of oil jumps 15% in the next month—before USO rolls again into the May contract—investors will only break even.

This contango effect killed oil investors in January, according to Standard and Poor's, which runs the most important commodity index in the world.

"The steep contango in the WTI crude oil futures market (when further-out futures trade at a premium) was the primary factor causing the S&P GSCI Crude Oil Index to decline 18.90% in January. The spot price of crude oil dropped 6.55% on the month, but rolling from the February to the March future contacts accounted for most of the remaining 12.35% of the decline in the component index."

Got it? Contango cost you 12% in January. And it's worse now.

What's so horrible about watching people plow their money into an investment that they don't understand is that there are so many nice, viable alternatives out there.

The same company that offers USO offers a great little fund called the U.S. 12-Month Oil Fund (NYSE Arca:USL). Rather than simply holding the near-month futures contract, USL holds equal positions in each of the next 12 months' worth of futures contracts. Spreading out its bets like that helps minimize contango, which tends to be worse in the near-month contract, and gives you more direct exposure to the spot price of crude.

Not surprisingly, over the past three months, USL has outperformed USO by 13%.

7 Comments – Post Your Own

#1) On February 25, 2009 at 1:05 PM, IBDvalueinvestin (99.66) wrote:

USO will sell its current Oil contracts over a  4 day period starting in March.

NEW YORK (Dow Jones)--The United States Oil Fund LP (USO) will roll its positions in Nymex crude oil futures over a four-day period starting in March, the fund said in a filing.

The exchange-traded fund uses investments from shareholders to purchase long positions, or bets that prices will rise, in oil futures on the New York Mercantile Exchange. The fund has grown rapidly, recently accounting for about 22% of all outstanding front-month contracts.

As the fund grew in size, its "roll" became more noticeable to the wider market. On a predetermined day each month, USO has sold its holdings in the front-month futures contract and has bought into the next month. The sheer size of the roll would pressure front-month prices, while exaggerating the gap between monthly futures contracts. USO is also paying a steep price to roll, as the second-month contract has traded at a large premium to front-month futures since December.

USO will extend that period over four days beginning in March, it said in a filing with the Securities and Exchange Commission.

A longer roll won't necessarily lessen USO's impact on the market, or reduce its expenses, analysts said.

"While moving away from a one-day roll was necessary, it will not necessarily change anything to the distortions of the [futures] spreads into the roll," said Oliver Jakob, with Petromatrix. "It could provide even worse returns to the holders of the [fund]."

USO's roll will now overlap with other exchange-traded funds, including the S&P Goldman Sachs Commodities Index. That could increase selling pressure on the shared roll days, making it more difficult for all index funds to keep expenses low, Jakob said.

-By Brian Baskin, Dow Jones Newswires; 201-938-2062; brian.baskin@dowjones.com

(Nick Heath in London and Carolyn Cui in New York contributed to this article)

(END) Dow Jones Newswires

February 18, 2009 09:59 ET (14:59 GMT)

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#2) On February 25, 2009 at 1:21 PM, RussWild (< 20) wrote:

It doesn't help that I bought USO two days ago. I'm almsot hitting my limit order so I'll be out today hopefully.

Thanks for the information.

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#3) On February 25, 2009 at 1:32 PM, maxhoffa (< 20) wrote:

are there any advantages to short term contango?  i'm thinking that if it keeps USO trading at a discount, i could theoretically get into USO well after i identify any significant upward move in oil price.  

 so if i'm a long term oil bull, which i think i am, isn't there an advantage to near term discount in USO price?  i guess if contango lasts indefinitely it's a serious problem for an ETF like O, but if it's a short term market artifact, is there a potential benefit to it?

just curious.  i know little about contango. 

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#4) On February 25, 2009 at 1:47 PM, JakilaTheHun (99.93) wrote:

are there any advantages to short term contango?  i'm thinking that if it keeps USO trading at a discount, i could theoretically get into USO well after i identify any significant upward move in oil price.  

There must be some advantage because USO is beating USL by a significant margin today.

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#5) On February 25, 2009 at 2:00 PM, JakilaTheHun (99.93) wrote:

A better article on the subject:

http://seekingalpha.com/article/118407-the-hidden-leverage-of-oil-etfs

It depends on the type of market.  Backwardation means higher returns for USO.

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#6) On February 25, 2009 at 3:49 PM, buildgreen (< 20) wrote:

Bought USO based on this and other analysis. Sold today. Booked 11% in 2 days. I have to thank everyone here for your time and insight. This has become an immensly valuable resource and dare I say community.

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#7) On February 25, 2009 at 3:50 PM, buildgreen (< 20) wrote:

Typed too fast.. UCO.

 

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