USO Investors — Beware of The Contango!

The current low oil prices have raised the interest of some investors to go long on oil in the hopes that prices will eventually recover to their levels recorded in the past couple of years. For those who consider taking a long position on crude oil for a long period of time should take notice of the perils related to the oil ETF United States Oil Fund (USO). Mainly the adverse impact the Contango in the future markets that could result in a lower return on USO compared to the spot oil price. Let’s see why.

In order to make my point clear, let’s consider the time when oil prices were around $40 back at the end of 2008. It took roughly two years for oil prices to bounce back to around $90. The chart below presents the normalized prices (December 1st 2008) of crude oil WTI and USO between December 2008 and December 2010.

USO WTI 2008

Source of data: EIA and Google finance

As you can see in the chart above, even though the price of WTI oil rose by 82% during this time frame; the price of USO actually declined by 4.5%.  This means, people, who bought USO during those years, wouldn’t have benefited from the recovery of crude oil (assuming they had held on to USO for the entire period).

The main issue that is responsible for this discrepancy is the roll decay related to Contango in the futures markets. You can also see a detailed explanation of this issue in the USO’s prospectus (pg. 17-23).

I have also talked about this issue in detail in a previous segment. Basically, Contango is a situation, in which prices of long-term futures are higher than prices of short-term futures. So when USO rolls over its future contracts (it sells its near future contract and purchases its next month’s future contract in order to maintain its position of near month oil futures), the price of USO tends to decline or at least underperforms crude oil prices.

Currently, the futures market is in Contango after being in Backwardation, a situation in which far term future markets are priced below near term futures, in the past few weeks. The chart below presents the changes in gap between short term and long term prices of oil futures over the past several months.

Contnago BackSource of data: EIA

This shift is expected to result in USO under-performing the price of WTI. In such a scenario, even if oil recovers, USO is likely to underperform oil prices, as presented in the first chart herein.

Keep in mind, investing in USO over a short period of time is likely to follow WTI with little deviation from its price (assuming the Contango in the futures markets isn’t too big). Here is an example of the normalized prices of WTI and USO between January 13th, 2014 and April 14th, 2014. During this time frame WTI rose by nearly 12% from $92 to $104 per bbl.

USO WTI April 2014Source of data: EIA and Google finance

As you can see, USO actually slightly outperformed WTI as it increased by 13%. This is because the futures markets were mostly in Backwardation. In any case the impact of the Contango/ Backwardation on the performance of USO compared to WTI oil price was very minimal.

The current Contango in the oil futures markets is likely to result in USO under-performing WTI especially over long periods of time. Therefore, investors should take notice of the current situation in the oil future markets before purchasing USO. For more see: “On Falling Oil Prices

 

Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.