HardAssetsInvestor

Written by Brad Zigler  |

February 10, 2009

Contango's Cost To Oil ETF Investors

Details

We at Hard Assets Investor have written about contango and backwardation many times. The message is worth repeating in times like these.

Just what sort of times are these? And what the heck are contango and backwardation?

Contango and backwardation describe pricing structures in the futures market. In a contango, nearby deliveries are cheaper than deliveries in later months. The latter-month premia mostly reflect the cost of carrying the commodity, e.g., financing, storage and insurance. The existence of a contango implies there's something to carry; you're not likely to see contango in a tight market.

Backwardation represents the opposite: Nearby contracts trade at higher prices than deferred deliveries. And, as you might expect, backwardation typically develops when current supplies are short.

The crude oil market regularly – well, maybe irregularly – flips from contango to backwardation, and back again, depending upon market participants' perception of supply and demand. Crude's last turnover was into contango last summer. As wheels fell off the economic bus in recent months, oil's contango widened to record levels.

That's knocked hell out of long-only oil ETF returns like the United States Oil Fund (NYSE Arca: USO). Rolling the long front-month oil position, as required by USO's methodology, has been costly.

Just how costly?

This year, USO has lost 14.7%. The NYMEX spot contract's given up 11.3% over the same time. That's just 26 trading days, about 10% of the year. Annualize the negative roll yield and you can project a per-annum cost of over 28%. Ouch!

Oddly enough, another long-only fund actually has gained ground this year. It's USO's sibling, the United States 12-Month Oil Fund (NYSE Arca: USL). USL's managed a year-to-date gain of 2.7%, because it's valued against the average price of the dozen most-nearby NYMEX crude oil contracts. Contango is thus turned from a liability into an asset.

USO, USL Vs. NYMEX Spot Crude Oil

Oil Portfolios Vs. Futures

Comparing USL's numbers with USO's, you're struck immediately with the vast disparity in volume. Millions of USO shares change hands daily compared with only small lots of USL. Much of that is institutional and hedge fund activity, including short sales. USO is sought for its tighter correlation to oil futures.

USL is younger and certainly less well-known. This year, though, USL volume has ballooned. More than 293,000 shares traded on Monday, for example. This intimates large fund positioning.

There's more liquidity in USL than the volume numbers imply. First, bid/offer spreads aren't exceptionally disparate. Seventeen basis points isn't very wide compared with many other ETFs trading similar volumes. An analysis of USL's liquidity index indicates that a trade of 3,750 shares could move the market 1%. At current price levels, that's a $115,000 investment. Perhaps too small a hoop for a CalPERS to jump through, but roomy enough for most retail investors.