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).

Here’s a trading opportunity you don’t see every day!

On March 31st 2007 Uranium Participation Corp. (U) had a NAV of $12.38, while it traded for $16.00 on the Toronto Stock Exchange. After a spike up to a high of $18.76, it is now back to $16 a share (all amounts Canadian). That represents a premium of approximately 23% to the underlying commodity.

Since Uranium Participation represents actual uranium (the commodity), I’ll be going short the Uranium Participation Units and long the upcoming NYMEX UxC Uranium futures to arb out this premium. My only risk will be currency exposure between the US and Canadian dollar but since this should be a short term trade, that’s acceptable to me.

As of April 13th 2007, the short position of U on Toronto Stock Exchange, was 2,479,300 shares. This was a reduction from the 3,416,000 sold short on March 30th, 2007. I wish the exchanges would release this info with less time lag!

This trade is a great example of a non-directional trade. Although both positions are in uranium, the actual price of uranium doesn’t have to move for the position to be profitable. All that has to happen is a collapse of the NAV premium in Uranium Participation Units (U) to reflect the real uranium prices on the NYMEX.

By the way, this happened before when Central Fund of Canada Limited (CEF.A) - a closed-end fund in Canada investing in gold and silver - had its premium collapse after the introduction of the streetTRACKS Gold Trust ETF (GLD) and the iShares Silver Trust ETF (SIL).

Watch Out!
Historically, the introduction of a new contract has usually meant an intermediate high in prices. But since this is non-directional, it won’t affect me. If you’re long uranium or uranium stocks though, we could be in for a rough patch as this is a reliable contrarian indicator.

The other dark cloud on the horizon is that according to inflation adjusted prices, we are almost at the previous high (~$115/lb) last seen in the late 1970’s. After a parabolic move up within a few short years, I won’t blame anyone for being nervous to see prices at previous resistance levels.

Cheatsheet for the upcoming NYMEX UxC Uranium futures contract:

• U₃O₈ (yellowcake) is concentrated uranium oxide produced from uranium ore and is the most actively traded uranium-related commodity. Its primary use is as fuel for nuclear reactors.
• NYMEX UxC Uranium U₃O₈ futures will be launched at 6:00 pm May 6, 2007 (Sunday) for the trade date of May 7, 2007 (Monday).
• Contract symbol will be UX
• Contract size is 250 pounds of uranium U₃O₈ (currently spot price: $113/lb.)
• Minimum tick size is $0.05
• It will be a financially settled contract with each month settling on the corresponding spot month-end U₃O₈ price published by The Ux Consulting Company.
• Trading hours are 6:00 PM through 5:15 PM, New York time, Sunday thru Friday, with a 45 minute break each day between 5:15 PM and 6:00 PM.
• Initially, 36 consecutive months will be listed. The first listed month will be June 2007.

While most of our attention is raptly focused on the current upturn in the equity market, a massive, stealth bull market has been ongoing for a few years, right under our very noses. I’m referring to the uranium market of course. You never hear about it on CNBC and you never read about it on the Wall Street Journal. But uranium (commodity) and uranium stocks have been tripling and quadrupling all over the place.

Soon the NYMEX will begin to trade uranium futures. Until then, the only way to get your hands on the actual commodity is through the Toronto Stock Exchange’s Uranium Participation Units (U). I covered U almost a year ago saying:

…a 50% premium is ridiculous. I would patiently watch for an orderly pullback (with low volume) and allow for a more palatable entry.

The pullback did arrive a few months after I wrote that (and it was on low volume also). It kissed the support/resistance line at $7.50 and reversed up to almost double at a high of $19 - all amounts Canadian dollars.

The chart still looks fantastic. My only concern is that it is a bit extended from its long term moving average (200 simple MA in blue). But notice how it tends to bounce off its 50 day moving average. That is the sign of a very strong uptrend and while you could try and run counter to the major trend, why would you want to? It will go up until it won’t. Until then, go with the flow.

The other interesting security is Pinetree Capital (PNP) which isn’t a mining company at all. It is a merchant bank that specializes in the resource sector. They have a very diversified but cherry-picked portfolio. Normally you wouldn’t be able to access this sort of expertise outside of private investments and hedge funds.

The following are a few other uranium plays. Most are on Canadian exchanges (Vancouver and Toronto). The two that are co-listed in the US are Denison Mines (DML and DNN) and the bellwether Cameco (CCO & CCJ). In this sort of bull markets, it pays to go with smaller, lesser known companies since they usually have much higher betas.

ABN Consolidated Abaddon Resources
AXU Aurora Energy Resources
ALS Altius Minerals
BAY Bayswater Uranium
BTT Bitterroot Resources
CCO Cameco (NYSE: CCJ)
CVV CanAlaska Uranium
CXX Crosshair Exploration & Mining
DML Denison Mines (AMEX:DNN)
EMC Energy Metals (NYSE:EMU)
FCO Formation Capital
FDC Forum Uranium
FIU First Uranium
FSY Forsys Metals
FRG Fronteer Development
JNN JNR Resources
KRI Khan Resources
LAM Laramide Resources
MGA Mega Uranium
MZU Mesa Uranium
NWI Nuinsco Resources Limited
PDN Paladin Resources
GEM Pele Mountain Resources
PNP Pinetree Capital
PTU Purepoint Uranium Group
PWE Powertech Uranium
QTA Quaterra Resources
RSC Strateco Resources
STM Strathmore Minerals
SXR SXR Uranium One
TXM Triex Minerals
TVC Tournigan Gold
U Uranium Participation
UEX UEX Corporation
ULU Ultra Uranium
UMN UraMin Inc.
UPC Uranium Power
URE Ur-Energy
UUU UrAsia Energy
UWE U308 Corporation
WNP Western Prospector Group