Tuesday, January 20, 2009 How Contango Affects Crude Oil ETF's and ETN's (USO

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http://www.marketfolly.com/2009/ ... e-oil-etfs-and.html

Tuesday, January 20, 2009How Contango Affects Crude Oil ETF's and ETN's (USO, OIL, DBO)The following is a Guest post on MarketFolly.com.

'tradefast'is the nickname of an independent equity trader who has more than 20years of market experience at a major financial institution and 2 hedgefunds. He now trades for a private investment fund, using a combinationof both fundamentals and technicals. (That sounds like our kinda guy!)

Hesat down to explain how contango affects the crude oil ETF's and ETN'smany investors and traders usually play, including USO, OIL, & DBO.He writes,

"The US Oil Fund (Ticker: USO) holds longpositions in West Texas Intermediate crude oil futures contracts, androlls these contracts forward each month. Like most futures traders,USO buys futures with leverage, putting up a small portion of the moneyto buy the contracts. The rest of the money is invested in Treasuries,which generates interest income for the fund.

Three factors playa role in determining the performance of USO: 1) changes in the spotprice of crude oil, 2) interest income on un-invested cash, and 3) the'roll yield'. The first two factors are easily understood, but thethird factor, 'roll yield' should be examined further in order todetermine the extent, if any, to which traders of USO will be surprisedby its performance in relation to spot crude oil.

First somebackground: Oil futures are available for each month of the year, soyou can buy a futures contract right now which gives you the right tobuy oil in February 2009, March 2009, April 2009, and so on. Currently,the price of oil in February 2009 is less than the price of oil inApril 2009, a condition which is referred to as 'contango'. (If theopposite were true, the market for crude oil would be inbackwardation.) Most commodity funds, including the US Oil Fund (USO)buy what is called the 'near month' contract and, because they do notwant to take physical delivery of the commodity, they sell the currentmonth's contract before it expires and buy into next month's contract.This process is called 'rolling forward', and it can result in the ETFpaying up if the forward month contract is higher than the currentmonth (contango), or cashing out if the opposition condition exists(backwardation).

To investigate the issue, I read through the 'risk factors' section of the USO prospectus.  The following is relevant:

inthe event of a crude oil futures market where near month contractstrade at a lower price than next month contracts, a situation describedas ‘‘contango’’ in the futures market, then absent the impact of theoverall movement in crude oil prices the value of the benchmarkcontract would tend to decline as it approaches expiration. As a resultthe total return of the Benchmark Oil Futures Contract would tend totrack lower. When compared to total return of other price indices, suchas the spot price of crude oil, the impact of backwardation andcontango may lead the total return of USOF’s NAV to vary significantly.In the event of a prolonged period of contango, and absent the impactof rising or falling oil prices, this could have a significant negativeimpact on USOF’s NAV and total return.

Inessence, the USO prospectus is warning traders that USO may experiencea negative 'roll yield' which may cause the NAV of USO to deviatesignificantly from the spot price of crude. Is there historicalprecedence for USO deviating from spot oil by a material amount? As itturns out, the answer is 'yes'.

Duringthe past two years, including 2006, these markets have experiencedcontango. This has impacted the total return on an investment in USOFunits during the past year relative to a hypothetical direct investmentin crude oil. For example an investment made in USOF units on April 10and held to December 31, 2006 decreased, based upon the changes in theclosing market prices for USOF units on those days, by 23.03%, whilethe spot price of crude oil for immediate delivery during the sameperiod decreased 11.18%

The conclusion, atthis stage of analysis, is that USO is not a direct play on the spotprice of crude oil - it is, instead, a play on the spot price, forwardprices, and the relationship between spot and forward (the slop of thefutures curve).

For a trader who is long USO, my instinct isthat maintenance or aggravation of the contango in crude oil will causeimpairment of the value of USO in relation to spot crude - whereas, anymitigation of the contango situation (including a shift to a flattercurve or backwardation) will enhance the performance of USO.

Iplan to study this issue more extensively. But, in the mean time, Iwill not consider USO to be a good proxy for the spot price of crudeoil - and I will be particularly leery of participating in USO foranything other than a short term trade."


'Tradefast'highlights an issue that many have overlooked or just not taken thetime to research. Many perceive that USO is the "best way to play oil"since it's the front-month contract. But, as he points out, there aresome issues with this ETF, depending on how crude oil is trading in thefront month and beyond. So, as always, read the prospectus of each fundyou're trading or investing in. It's important to understand whatexactly it is you're dealing with.

Inthe comments section of his original article, he goes on to addresssimilar issues in other crude oil ETF's and ETN's. Regarding tickerOIL, he writes,

"Here is a link to the prospectus for OIL, the IPath crude Oil ETN.

The'contango issue' is discussed on PS-10. Short answer: yes, a contangomarket in crude oil will result in negative roll yields - similar toUSO.

Also, be aware that OIL is an ETN (exchange traded note),rather than an ETF (exchange traded fund). With ETNs, you are anunsecured creditor of Barclays (the issuer of the note), so you havecredit risk overlaid on the risk of the commodity.

In a formerlife, I used to enter into total return swaps on various indices withLehman as the counterparty. I halted this practice long before LEHbecame a troubled credit. My sense is that the popularity of ETNs havefallen in relation to ETFs, because of the credit risk.

I haveno strong opinions regarding Barclay's default risk, but it might beworthwhile to consider that Barclays CDS widened by a meaningful 98 bpson Friday, and the stock declined 24%. Although the current CDS spreadof 265 bps is not indicative of extremely high default risk, the leveland direction are cause for some concern. (Barclays credit risk can behedged with CDS, but this is a market for instititional investors - andshorting Barclays stock against a long position in OIL exposes the OILholder to unacceptable basis risk. Ergo, I would prefer ETFs (such asUSO) over this specific ETN (OIL)."

He also addresses the Powershares ETF: DBO, writing,

"I took a quick glance at DBO from PowerShares.  In the prospectus, PowerShares notes the following:

Ratherthan select a new futures contract based on a predetermined schedule(e.g., monthly), each Index Commodity rolls to the futures contractwhich generates the best possible ‘implied roll yield.’ The futurescontract with a delivery month within the next thirteen months whichgenerates the best possible implied roll yield will be included in eachIndex. As a result, each Index Commodity is able to potentiallymaximize the roll benefits in backwardated markets and minimize thelosses from rolling in contangoed markets.

Myinterpretation of this statement is that the manager of the ETFutilizes a certain amount of discretion with respect to the futuresroll. If the forward curve were humped (i.e. backwarded to some point,and contango thereafter), a skillful manager might be able to takeadvantage. I do not claim expertise in this area, but my observation isthat the current market in Crude Oil is in contango as far as the eyecan see, and there does not appear to be any immediate advantage tohaving a selection of forward contracts with which to complete theroll. Also, keep in mind that with active management comes potentialadvantages (the manager may make a skillful maneuver) and potentialrisks (the manager may screw up and underperform the benchmark).

Currently,I am not commenting on the leverage associated with DBO, it is beyondthe scope of this particular topic (contango effects on crude oil ETFsand ETNs)."

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