Did you predict that oil prices would bounce in 2016? Nice call! Did you attempt to cash in by buying the biggest oil ETF? That’s where you went wrong. Oil prices have risen about 25 percent this year. But the USO ETF, which promises exposure to oil prices, has fallen more than 5 percent.
At the root of the USO’s trouble is the simple fact that oil set to be delivered in different months and trade at different prices. For instance, October oil trades at $44.59, November at $45.16, December at $45.79, January at $46.36, and oil to be delivered in December 2017 at $49.76. This array of prices forms the futures curve, and with each month’s oil trading at higher prices, the market is said to be in “contango.”
The way the USO endeavors to track oil is by continually holding the most relevant futures contract. The one tracking oil set to be delivered in the following month (until the contract is within two weeks of expiration). The problem comes when a contract’s expiration is near and the USO shifts to tracking the following month’s futures. At that point, the fund’s managers must sell its massive holding of the nearer-dated contract and buy about the same amount of the further-dated contract.
Since the further-dated contracts trade at higher prices, holders of the USO are selling low and buying high every single month. Meanwhile, oil producers are selling their oil in the futures market for higher prices giving oil prices a boost while the USO ETF takes a hit.
This explanation of the USO’s poor performance is likely cold comfort to those who have done so badly on a trade they may have thought was a home run. With a current market value of more than $3 billion, it may be a fair bet that many investors in this ETF had no idea that they would be so hurt by the structure of the futures market.
Retail investors who invested in the XLE (ETF) which contains the oil produces, drillers and refiners did quite well. Even the midstream master limited partnerships like Alerian MLP would have been a better choice. It is has a dividend yield of 11 percent.
Full disclosure I own some shares in Alerian in my retirement account.