Trader’s Narrative

I had read about the problems with US Oil Fund (USO) but it wasn’t until I plotted a simple graph comparing it to crude oil futures contract that I understood just how little badly it has performed:

The chart shows the ratio of USL to the crude oil futures contract (West Texas intermediate) since the ETF’s founding on April 10th 2006. Here are the four variables that influence the difference in the performance of the USO ETF vs. the crude oil futures which they are supposed to mimic:

• contango/backwardation
• MER (0.45%)
• rollover impact
• interest earned (on 90% of fund assets)

The MER is too low to account for the enormous valuation drift. So too is the (positive) effect provided by the interest earned on the majority of the ETF’s assets. Right now interest is so low that we can assume these two cancel each other out. Therefore, the other two variables are the key.

Contango occurs when later futures contract prices are more expensive than current contract prices. Backwardation is the opposite. We’ve been experiencing contango for about two years now. Right now the current NYMEX contract (November) is $70/barrel. Meanwhile the March 2010 is $72/barrel. This has meant that USO has had to buy slightly more expensive contracts every month, in effect, shaving a little off their asset valuation little by little.

As well, due to the gigantic size of the fund, the impact of rollover exacerbates the already existing difference between expiring and forward month contracts. As USO sells their holdings, they push down prices and as they buy, their demand increases prices. Of course, other market participants can count on their rollover to front run their obligatory monthly cycle.

All this means that the fund has done an abysmal job in tracking the crude oil market. From the start of the year until now, crude oil futures have gone up about 50%. But if you tried to replicate that by buying USO instead, you would have been out of luck as the ETF has gained less than 5% for the year.

To mitigate these concerns, a new fund was created: the United States 12 Month Oil Fund LP (USL). As the name implies, it holds 12 months worth of contracts so that each month only 1/12th of the fund is rolled over. While we have much less data for this ETF, as you can see by the chart below, the same valuation drift is at play:

Year to date, USL has returned about 16% while crude oil futures have increased in price by about 50%. A little better than USO’s horrendous under performance but still, not even close to tracking their underlying commodity.

The conclusion is that you shouldn’t simply assume that an ETF will do what it is supposed to do. Almost all ETFs and for that matter any retail structured product is created to “feed the ducks” when they’re quacking.

USO and USL are imperfect products when we use an intermediate to long term time horizon. They are appropriate for intra-day trading or swing trading but holding them as a proxy for the futures contract is self-defeating due to the valuation drift. If you want long term exposure to oil, buy the futures contract. Otherwise, buy small to medium size oil companies or explorers like Anadarko Petroleum (APC).

There a few ways to take advantage of the January effect this year:

Small & Micro-Cap ETFs
The simplest would be to buy small cap stocks or ETFs before the year end and hold until they have a pop. Since the definition of “small-cap” has been continuously revised up over the past few years, it might be a good idea to look at “micro-cap” stocks. Here are a few ETFs:

• iShares Russell Microcap Index (IWC)
• First Trust Dow Jones Select MicroCap ETF (FDM)
• Powershares Zacks Micro Cap Portfolio ETF (PZI)
• Powershares Dynamic OTC Portfolio ETF (PWO)
• iShares S&P SmallCap 600 Index Fund (IJR)
• iShares Russell 2000 Index Fund (IWM)
• iShares Morningstar Small Core Index Fund (JKJ)
• SPDR DJ Wilshire Small Cap ETF (DSC)
• Vanguard Small-Cap ETF (VB)
• PowerShares Dynamic Small Cap Portfolio (PJM)
• PowerShares Zacks Small Cap Portfolio (PZJ)

Closed End Funds
Last week I mentioned a method to capture January effect alpha which uses CEF and specifically, municipal/bond CEFs. This year is a bumper crop for this specific strategy because of the vast number of these funds which have severe losses.

Value Line Futures Index
Yet another way to play the January effect is to use the Value Line Arithmetic Index futures. This is a little known equity index compiled by Value Line Inc. - the investment research outfit. It is comprised of approximately 1,650 stocks which are equally-weighted, as opposed to capitalization weighted as in the S&P 500 Index.

The futures for this index are traded at the Kansas City Board of Trade with each contract valued at $25 times the value of the index (appx. 1324). The Value Line January effect strategy is pretty straight forward:

Buy the Value Line contract (nearby month of course) and (sell short) equal value ratio of the S&P 500 Index. Close the position in the first week of January. Depending on the calendar, around the 9th of the month. That’s it.

This simple spread trade has a remarkably high profitability ratio but sadly it only comes once a year. And the advantage it has to the other two year end strategies is that it is market neutral. Although I suppose you could short SPY to offset a long position in small/micro-cap ETFs.

It would seem that the stealth uranium bull market is over. After spending the past few years levitating non-stop into the stratosphere, uranium (U₃O₈) prices finally succumbed to gravity in June, topping out around $135/lb.

Since then prices have dropped to $90/lb (not shown on graph above). The effect on uranium stocks has been nothing short of devastating.

The Uranium Participation Units (TSE:U) traded on the Toronto Stock Exchange have dropped from almost $19 to $10. And whereas it used to trade at a premium to uranium spot price (sometimes as high as 50%!), not it is trading below NAV.

The last net asset value was July 31st at $14.04 - the August 31st numbers are still to come but I estimate them to be lower than July’s.

And while before it had bounced off it’s 50 day moving average, now it is below both the 50 day and the long term, 200 day moving average.

So what happened? I have no idea really. But I suspect it has something to do with demand and supply

Also, we had a rare contrarian indicator occur in early summer. At the beginning of May 2007, NYMEX started trading a new futures contract. Here’s what I wrote back then:

Historically, the introduction of a new contract has usually meant an intermediate high in prices…If you’re long uranium or uranium stocks though, we could be in for a rough patch as this is a reliable contrarian indicator.

As you can see on the chart, that coincides almost exactly with the top in Uranium Participation. Uranium itself hovered in thin air territory for another month or so:

I don’t like how most uranium stocks have cratered below their short term and long term moving averages. This sort of damage, especially when wrought over a short period of time isn’t at all conducive to the health of a bull market.

The only good thing I can see on the charts is that they are back at support (as you can see with the chart of Uranium Participation Units above).