USO hurting in contango

The USO/Crude divergence on Friday confused a lot of people; the buzzword on a number of blogs was "contango" and we received a few questions asking us to explain the disparity between the crude rip/USO tank.

First let's take a look at the two charts:

USO keeps moving away from 28 support and looks weak.

Crude however had a nice move on Friday (Feb contracts expired) and if we get continuation this week we could be looking at bottoming action.

So what is going on? In one word, it's called "contango" which means that the oil market is in a state in which the near month's contracts trade at a lower price than the next month's contracts. USO strategy is based on owning the near month contracts and before these expire, selling them and buying the next month's contract. By constantly rolling these forward in the current state of contango, USO loses value every month as it pays more for the forward month contract which is higher than the current month. To illustrate this for Friday: March contract rallied while USO, which holds now the April contract, went down.

This means that in a state of contango, USO, will under-perform (negative roll yield) but would do much better in the inverse state of backwardation (where the near month's contracts trade at a higher price than the next month's contracts). In USO's own prospectus one can read, "In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant impact on USO Fund's NAV and total return".

So what to do if you want to hold oil as an investment? Buy an oil tanker! What if you want to stick to equities? The best two alternatives are USL (which owns the current month and following 11 months of contracts, thus somewhat diminishing the contango effect) and DBO (where managers do not have a pre-determined schedule, like USO, but attempt to actively find the best possible yield). However, neither is liquid (even though volume has picked up substantially in the last few months).

As a side note: contango spreads are now tightening and we are looking at being buyers of USO in the near future.

If you are interested in the USO/Contango issue, read ahead from USO's own prospectus which explains the situation very well:

(pp 47-48 )

Term Structure of Crude Oil Futures Prices and the Impact on Total Returns

One factor that impacts the total return that will result in investing in near month crude oil futures contracts and ‘‘rolling’’ those contracts forward each month is the price relationship between the current near month contract and the next month contract. For example, if the price of the near month contract is higher than the next month contract (a situation referred to as ‘‘backwardation’’in the futures market), then absent any other change there is a tendency for the price of a next month contract to rise in value as it becomes the near month contract and approaches expiration. Conversely,. Several factors determine if the price of a near month contract is lower than the next month contract (a situation referred to as ‘‘contango’’ in the futures market), then absent any other change there is a tendency for the price of a next month contract to decline in value as it becomes the near month contract and approaches expiration.

As an example, assume that the price of crude oil for immediate delivery (the ‘‘spot’’ price), was $50 per barrel, and the value of a position in the near month futures contract was also $50. Over time, the price of the barrel of crude oil will fluctuate based on a number of market factors, including demand for oil relative to its supply. The value of the near month contract will likewise fluctuate in reaction to a number of market factors.

If investors seek to maintain their holding in a near month contract position and not take delivery of the oil, every month they must sell their current near month as it approaches expiration and invest in the next month contract.

If the futures market is in backwardation, e.g., when the expected price of oil in the future would be less, the investor would be buying next month contracts for a lower price than the current near month contract. Hypothetically, and assuming no other changes to either prevailing crude oil prices or the price relationship between the spot price, the near month contract and the next month contract (and ignoring the impact of commission costs and the interest earned on cash), the value of the next month contract would rise as it approaches expiration and becomes the new near month contract. In this example, the value of the $50 investment would tend to rise faster than the spot price of crude oil, or fall slower. As a result, it would be possible in this hypothetical example for the price of spot crude oil to have risen to $60 after some period of time, while the value of the investment in the futures contract will have risen to $65, assuming backwardation is large enough or enough time has elapsed. Similarly, the spot price of crude oil could have fallen to $40 while the value of an investment in the futures contract could have fallen to only $45. Over time if backwardation remained constant the difference would continue to increase.

If the futures market is in contango, the investor would be buying next month contracts for a higher price than the current near month contract. Hypothetically, and assuming no other changes to either prevailing crude oil prices or the price relationship between the spot price, the near month contract and the next month contract (and ignoring the impact of commission costs and the interest earned on cash), the value of the next month contract would fall as it approaches expiration and becomes the new near month contract. In this example, it would mean that the value of the $50 investment would tend to rise slower than the spot price of crude oil, or fall faster. As a result, it would be possible in this hypothetical example for the price of spot crude oil to have risen to $60 after some period of time, while the value of the investment in the futures contract will have risen to only $55, assuming contango is large enough or enough time has elapsed. Similarly, the spot price of crude oil could have fallen to $45 while the value of an investment in the futures contract could have fallen to $50. Over time if contango remained constant the difference would continue to increase.

Historically, the oil futures markets have experienced periods of contango and backwardation, with backwardation being in place more often than contango. During the previous two years, including 2006 and the first half of 2007, these markets have experienced contango. However, starting early in the third quarter of 2007, the crude oil futures market moved into backwardation. The crude oil markets remained in backwardation until late in the second quarter of 2008 when they moved into contango. The crude oil markets remained in contango until late in the third quarter of 2008, when the markets moved into backwardation.

While the investment objective of USOF is not to have the market price of its units match, dollar for dollar, changes in the spot price of oil, contango and backwardation have impacted the total return on an investment in USOF units during the past year relative to a hypothetical direct investment in crude oil. For example, an investment made in USOF units made during the second quarter of 2007, a period of contango in the crude oil markets, decreased by -0.71%, while the spot price of crude oil for immediate delivery during the same period increased by 7.30%. Conversely, an investment made in USOF units during the third quarter of 2007, a period in which the crude oil futures market was mostly in backwardation, increased by 17.82% while the spot price of crude oil increased by 15.53% (note: these comparisons ignore the potential costs associated with physically owning and storing crude oil which could be substantial).