If you like oil, don't buy USO, buy USL

[FUEGO]

At least according to this article:

ETF Investors Mistakenly Stock Up on USO: Buy USL Instead -- Seeking Alpha

USO rolls their front month oil futures contracts over into the next month's contract each month. Right now the oil commodity market is suffering from contango, or an upward sloping forward curve. This means next month's contract is much more expensive than this month's contract. So when USO rolls over they are currently losing $6-7 per bbl.

USL, run by the same company as USO, owns the next 12 months of oil futures contracts in equal parts, so doesn't suffer from contango anywhere near as much as USO.

Oil investing isn't for me, but I know some on here were/are in it.

 

[REWahoo]

FUEGO, thanks for posting this. Looks like I saddled up the wrong horse...again.

 

[mn54]

How does OIH and OIL compare as an investment in oil as USL?

 

[ziggy29]

Random thought for anyone who might hold these things in a taxable account: I wonder if selling USO at a loss and buying USL would be a wash sale...

 

[FUEGO]

Random thought for anyone who might hold these things in a taxable account: I wonder if selling USO at a loss and buying USL would be a wash sale...

I would say no. They own different underlying securities and obviously have different performance results. I highly doubt it would be "substantially similar" or whatever the language is per the IRS rules.

 

[ziggy29]

I would say no. They own different underlying securities and obviously have different performance results. I highly doubt it would be "substantially similar" or whatever the language is per the IRS rules.

That would be my gut feeling, too, but you never know because there's only so many cases they've ruled on.

 

[haha]

I think either one of these is flawed, and the good historical results from this type of vehicle depended on the markets being in backwardation during the time that the funds first results were established and marketed.

Although it is a different investment, I would look at some well diversified energy or oil and gas etfs, cefs, or mutual funds.

I suppose that if you are worried about tracking error against WTI these are not perfect, but they at least do not have built in losses under the most common market condition, which is contango.

Ha

 

[FIRE'd@51]

Be careful here. Contangos can narrow also, or even go into backwardation.

The price of USL represents the price of all the futures contracts it owns. If you buy it now, you are not avoiding the contango, you are paying for it upfront.

Look at the table in the article. Purchasing USL means, for example, you are buying AUG oil at $52.70 per barrel. Mar oil is $40.42 (actually they are both lower but I'm using table prices for my example). This means spot oil has to rise some 30% by August in order for you to break even on those contracts.

Currently the contango is greater than the cost of carrying the oil. This means anyone buying future oil is overpaying for it. In fact they are taking the other side of the oil contango arbitrage, in which oil traders buy spot oil and sell it forward via the futures. Since the Cushing, OK oil storage tanks are basically full, the contango has widened enough that arbitrageurs are using VLCC tankers to store the oil for forward delivery. This activity will eventually depress the contango, which will tend to hurt USL relative to USO.

My guess is the reason USL outperformed USO over the last 3 months is that the contango widened. Remember, contangos can narrow also.

I would only buy USL instead of USO if I had reason to believe that the contango was going to increase further. Since it's already overpriced relative to the carry, I think that may be a bad bet. If you want to own spot oil, I would go with USO and live with the roll risk.

 

[clifp]

Be careful here. Contangos can narrow also, or even go into backwardation.

The price of USL represents the price of all the futures contracts it owns. If you buy it now, you are not avoiding the contango, you are paying for it upfront.

Look at the table in the article. Purchasing USL means, for example, you are buying AUG oil at $52.70 per barrel. Mar oil is $40.42 (actually they are both lower but I'm using table prices for my example). This means spot oil has to rise some 30% by August in order for you to break even on those contracts.

Currently the contango is greater than the cost of carrying the oil. This means anyone buying future oil is overpaying for it. I.

Thanks FIRE good analysis. I was wondering if I didn't screw by buying USO. It seems odd with world face potential deflation that price of Oil futures is up so sharply. The implied interest rate on the future contracts is huge.

My bet and partial inflation hedge is that price of oil will be significantly higher 3 to 5 years in the future. Is USO the best investment vehicle for making such a bet?

 

[Hal3]

The volume on USO is way up but the price isn't moving.
Any thoughts on this?

 

[ziggy29]

I mentioned the contango angle in another thread. It might be interesting to watch the relative movements of USO and USL. Might we conclude that if USO outperforms USL, the contango is shrinking, and if USL outperforms USO then the contango is increasing?

 

[Hal3]

Here's an interesting article from a year ago:

ETFs with the Largest Short Interest -- Seeking Alpha

USO was near the top of the list for short interest - about 200% of shares outstanding. The rec was to buy because short interest would send the fund soaring when the market rallied. That was Feb 24, 2008. I guess the shorts didn't see the $4.00 oil.

I just can't see oil getting any cheaper and I don't see why it is so very cheap now.

I am tempted by USO.

 

[FIRE'd@51]

Might we conclude that if USO outperforms USL, the contango is shrinking, and if USL outperforms USO then the contango is increasing?

Yes, although it's the front two month's contango that USO is particular sensitive to, since they roll futures every month to avoid taking delivery.

 

[Hal3]

RE: contango - I confess that I was unfamiliar with the term. (From Wikipedia)

"Some believe that in 2005 and 2006 the crude oil market was in contango. This was a result of the perception either of a future supply shortage or a present supply gluts. Many traders may have taken advantage of the arbitrage opportunity by buying present oil, selling a future contract and then simply storing the oil for future delivery. It was estimated that perhaps a $10-20 per barrel premium was added to spot price of oil as a result of this. If such is the case, the premium may have ended when global oil storage capacity became exhausted, however the contango would have deepened as the lack of storage demand to soak up excess oil supply would have put further pressure on prompt prices. However, as crude and gasoline prices continued to rise between 2007 and 2008 this practice became so contentious that in June of 2008 the Commodity Futures Trading Commission, the Federal Reserve, and the SEC decided to create task forces to investigate whether this took place. A crude oil contango occurred again in January 2009, with arbitrageurs storing millions of barrels in tankers to profit from the contango."

It is interesting that the slide from $4.00 oil started with the investigations beginning in June, 2008.

 

[haha]

I mentioned the contango angle in another thread. It might be interesting to watch the relative movements of USO and USL. Might we conclude that if USO outperforms USL, the contango is shrinking, and if USL outperforms USO then the contango is increasing?

For a more direct method, why not just look at the contracts?

Intraday Futures Prices - Markets Data Center - WSJ.com

Ha

 

[FIRE'd@51]

Is USO the best investment vehicle for making such a bet?

I'm not sure if it's the best - the contango does give me concern. There is an ETF on Brent Crude that trades in London (the symbol is OILB). As I understand it, they roll Brent Crude futures, which are cash-settled, so they don't have to worry about delivery. I haven't followed them closely, but they seem to exhibit less contango, probably because of the cash-settlement

 

[FIRE'd@51]

IMO, the April contract is probably the better indicator of where the oil price really is. The March contract's last trading day is next Friday, so I think there is a lot of selling pressure on that contract right now as traders try to roll their positions to avoid delivery. USO seems to roll their positions a couple of weeks prior to the last trading day of the front contract.

 

[CCdaCE]

I thought this article had some good explanations on why USL is better than USO. Namely that USL has 12 mo. worth of contracts. As opposed to USO just having 1 month.

Is the USO A Piece of Junk? - ForexHound.com trading news from the FX world

-CC

 

[ziggy29]

I thought this article had some good explanations on why USL is better than USO. Namely that USL has 12 mo. worth of contracts. As opposed to USO just having 1 month.

Is the USO A Piece of Junk? - ForexHound.com trading news from the FX world

From the article:

As mentioned above, the USO was created as a proxy to track the price of oil. When the fund was first created, its price was exactly 1-1 that of the current future’s month oil price.

Yikes. I'm pretty sure the current price of next month's contract isn't below $25. The last quote I saw from Gloomberg was $39.74.

 

[al_bundy]

Random thought for anyone who might hold these things in a taxable account: I wonder if selling USO at a loss and buying USL would be a wash sale...

like the IRS will ever figure it out

 

[ziggy29]

like the IRS will ever figure it out

Not unless you're audited. But isn't that true about a lot of other fudging on your taxes, too?

 

[Gearhead Jim]

If you don't know (and I admit that I don't know) how contango and backwardation will go in the future, would it make sense to buy both USO and USL? Would that reduce the problem and cause your total investment to more closely track the actual price of crude?

How about UGA, which tracks gasoline prices? I can't find out how contango effects that one.

 

[ziggy29]

If you don't know (and I admit that I don't know) how contango and backwardation will go in the future, would it make sense to buy both USO and USL? Would that reduce the problem and cause your total investment to more closely track the actual price of crude.

Could be. I'm no expert, but I would think that USL would be less volatile than USO, both on the downside and the upside.

 

[Gearhead Jim]

Could be. I'm no expert, but I would think that USL would be less volatile than USO, both on the downside and the upside.

That's what I thought, but I seem to remember a story about how USO went down more than oil went down last Fall.
We appreciate how you took one for the team last year, but we don't want to duplicate your experience.

 

[FIRE'd@51]

I think there is a fallacy in comparing the performance of ETF's, like USO and USL, to the spot price of oil. When one looks at the spot price of oil, he is looking at the front month's futures contract. However, when the spot price six months from now is compared to today's price it is computed as a simple ratio, as if there were no storage and financing costs. Thus, it is impossible for anyone to actually match the performance of spot oil as calculated. To do so, you would have to store the oil for free in your back yard. Typically, storage costs run around 1.5 cents per day per barrel, or about $0.45 per month. In addition there is a financing cost representing the opportunity cost on the money tied up in holding a barrel of oil. At 6% with spot oil price at $45 per barrel, this would be another $0.23 per month. Together, these costs represent about $0.70 per month, which means next month's futures should trade $0.70 higher than this month's (i.e. the spot price), and so on. Thus oil for delivery one year in the future, if efficiently priced, should trade $8.40 above today's price (approximately where it is today). In theory, the financing cost should be able to be recovered by investing the money collateralizing the futures in short-term fixed income securities. In reality, this is usually not possible due to the difference in borrowing and lending rates.

There will always be contango in an efficiently priced futures curve, due to these financing and storage costs. This contango will necessarily lead to a frictional loss in your position. This friction is simply the cost of carry. Holding USO or USL will simply realize this loss. If the futures curve is efficient, either ETF should track spot oil as best as is physically possible. If the futures curve is inefficiently priced, one should hold either USO or USL depending upon whether the futures curve is rich or cheap relative to the cost of carry. A month ago the futures curve was overpriced, i.e. it was possible to buy spot oil (the front month contract) and sell it forward, store the oil and deliver it in the future and make an arbitrage profit. The contango has narrowed to the point where this trade is less profitable. That is why USO has outperformed USL over the past month.

IMO, the trade that should have been done a month ago, was buy USO and sell USL short. This trade would have earned approximately 10% over the past month, as the contango narrowed toward fair value. Should the futures curve go into backwardation, one should buy USL and short USO. When the futures curve is fairly priced, it doesn't matter which ETF you hold, as both will perfom identically, but neither will match the performance of spot oil the way it is calculated, because the calculation as done in practice doesn't include the cost of carry.