USO death by contango (Part 1 of 2)

Relevant links attached to part 2

Transcript of the videos (two parts) follows, but shortened as youtube don't have the space ;-)

USO (United States Oil) is an etf, exchange traded fund, which uses futures contracts to track the price of oil.

Let's say that I buy futures contracts for oil, with March expiry, at a price of $35. This gives me the right to take delivery of crude oil at that price when the contract expires.

NYMEX Crude oil futures quotes
http://futures.tradingcharts.com/marketquotes/index.php3?market=CL

Now, USO doesn't have the facilities or inclination to take delivery of oil. Neither do I. Neither do the majority of traders in oil futures. Many are settled for cash instead of oil.

The method used by USO, and other similar funds such as OIL, to keep a continuing position in the oil price is to 'roll out' the contracts to the next month when the current contract is close to its expiry date.

This sounds complex, but it isn't.

So, that contract to buy oil at $35 in March we talked about might be worth, say, $38 when we come to roll it out, as short term oil prices are volatile and there have been many bounces and false starts along the way during oil's incredible collapse since July of last year. So, you know, $35 to $38, - perfectly feasible.

Great, that's a $3 profit for the USO fund. So far so good.

However, there is a point I would like to explain in detail for you as it is little understood by most investors currently buying USO in hopes of timing a bottom in oil. The thorn in USO's side goes by the name of contango. C O N T A N G O and this simply means that the futures contract price for oil in future months is higher than the current month. A steep contango (when the futures price for several months out is much higher than the current month) is killing USO's value as a proxy for long oil at the moment.

So, in other words, if someone wants to buy the USO fund long there might be days when oil goes up but the USO fund hardly moves. Or, particularly when USO rolls out its contract, they see terrible losses. So much so that recently USO has hit a new low even though the actual oil price hasn't.

Anyway, a steep contango is killing USO's value.

Bear with me on this explanation; I'm sure its worth the effort if you are interested in understanding USO 's recent abysmal performance.

Ok, so, as there is speculation that oil prices will rise dramatically in future - due to maybe further OPEC cuts, a collapse in the dollar, or simply a technical rebound from an extremely hammered price - the price of contracts for, say, April are considerably higher than they are for March. May is higher again and so on further out over coming months.

Now, I'm not going to make a prediction on oil prices here, and I'd like to ignore, for the sake of factual analysis over guesswork, any inference that oil is going to be higher in several months just because oil traders are bidding up the price for the futures. Let's just accept that they are, and stick to looking at USO's position for the purpose of this video.

Ok, well, let's get to the meat of this situation.

USO sold those contracts for $38 but must pay, say, $42 for the next month contracts. As the fund only has the money provided by investors, their funds are finite, and they are pretty much 100% invested in oil futures all the time, it doesn't take a genius to see that they can only buy much less oil at $42 than they had when they held the $38 contracts.

(***NOTE: in the video this contract is referred to as "The $35 contract". I hope it is clear that I meant that March contract and that the point is the loss made on rolling out the contract to a higher priced futures contract. Probably self-explanatory, but thought it worth mentioning.)

The fund makes a loss and this is reflected in the price of the fund. Note that the price of the fund is a function of the financial position of the fund. The idea of it tracking oil prices is only the intent of the fund, in reality it has to operate in the market and try as best it can to fulfill that goal.

So, anyway, with that situation the fund has less oil when the contracts are rolled out into a steep contango so each share of the fund represents less oil following the roll out.

And that is why the performance of the USO fund has been so 'piss poor', and why it has been the short sale of choice for oil traders following the genuine collapse of oil prices down over the last half year or so.

I first realized the contango problem in early 2007 when oil took off for the moon following a deep collapse from the end of 2006. Oil skyrocketed but USO took ages to get anything like back into step with oil prices, much to the chagrin of frustrated USO investors.

See part 2 for continuation.............

Category:

Education

Tags:

• USO
• etf
• trading
• stocks
• fund
• oil
• contango

[Bentotrading]

So if backwardation happened then USO would be perfectly tracked ?

[Ben1607]

"a steep contango... is killing USO's value as a proxy for long oil at the moment. Some days oil will go up, and USO will hardly move"

can someone clarify this for me? specifically I am tripping over the point: how can "oil" "go up" and USO be uneffected?

[fox20012]

dont take this down lol, unless ur going to add more info, very good information 5*