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).

So the Fed gave $2 Trillion to some banks but won’t name them. Remember that? Bloomberg is suing them to get the information, Congress is asking and being rebuffed. But the WSJ got the scoop!

That and more, in this week’s reading list at news.tradersnarrative.com:

• Fed Using Enron Style Acctg to Bailout Wall St.
• WSJ Names Names: Who Got Secret Fed Money
• (Expected) SEC Fee Increase in April
• Tricks of the VIX
• When Will the Bull Return?
• Credit crunch tent city haunts California
• Investment Banks receive $50 through backdoor
• USO Finds Itself at the Mercy of Traders
• Dispelling Myths About Stocks in the 1930s

And remember to check regularly since there are links added regularly throughout the week.

There is a well worn adage on Wall Street that says, when the ducks quack, feed them.

Want to see it in action?

Here’s the gold ETF from its IPO in November 2004:

And here’s the recent silver ETF: