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IBDvalueinvestin (99.64)

USO explodes UP now trading at $25.87

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February 25, 2009 – Comments (1) | RELATED TICKERS: USO

Don't know what to make of it. I already said Oil March contracts will fall once we enter March.

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#1) On February 25, 2009 at 12:22 PM, IBDvalueinvestin (99.64) wrote:

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%.

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