HardAssetsInvestor

Written by Brad Zigler  |

December 20, 2007

USL Oil ETF: The Early Innings

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You can't always tell how a baseball game will end just by watching the first inning. Then again, a blowout often has its start in the early goings.

There's no blowout - at least not yet - brewing in the oil ETF market. But there may be a championship play in the offing.

The United States 12-Month Oil Fund (USL) now has a few trading days under its belt. USL, you may remember, was devised to mitigate the ravages of contango, or negative roll yield, on crude oil futures returns. USL's price is based upon the average of the nearest 12 delivery months of NYMEX crude oil futures.

Timing is everything in the commodities markets. Unfortunately, USL's launch was timed to miss the oil contango entirely. By the time USL came to market, the crude oil market inverted into backwardation.

So, does that mean that USL will underperform its longer-lived cousin, the United States Oil Fund (USO) which tracks the nearby delivery?

Not if the first few days of trading are a reliable indicator. Since December 6, West Texas Intermediate, the basis grade for delivery against NYMEX crude contracts, has risen, albeit raggedly, 0.91%. USO, meanwhile, gained 1.59%, implying an annualized incremental pickup of better than 23%.

And USL? The new ETF cranked out a 1.73% gain in its first two weeks. If things just stay as they are - and what's the likelihood of that? - USL investors could outdo USO holders by 5% a year. In an inverted market, mind you: The average monthly backwardation of NYMEX crude is now 25 cents per barrel.

The reason? It's volatility coming to bat. The greatest price variance found in the crude market is typically in the front months. USO, based on the nearby contract, is exquisitely sensitive to this, while USL is more insulated. Since the portfolio was launched, USL's standard deviation has been 28.50% compared to USL's 35.18%. Less volatility means lower drawdowns. Lower drawdowns, in turn, lead to higher compound returns. If you give up less on downdrafts, you need smaller subsequent gains to get you out of the hole.

Keep in mind, we're in the very early innings of this game. But if this condition holds up, USL could be headed for the World Series.

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