USO - death by contango - (Part 2)

Relevant links....

USO vs. DBO - note the periods of out/under performance, generally due to the state of contango.
http://finance.yahoo.com/q/ta?s=USO&t=2y&l=on&z=l&q=l&p=&...

Contango vs. backwardation explained.
http://www.investopedia.com/articles/07/contango_backwardation.asp

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

Oil seasonals - article with chart included.
http://www.safehaven.com/article-5692.htm

Frontline Tankers homepage
http://www.frontline.bm/

Transcript of the videos (two parts) follows.......

Part 2..............

When oil prices collapse but begin to sound out for a bottom this will often first show up in the futures contracts, usually for summer. It might surprise some people to find that the seasonal low for oil prices is around Jan/Feb, and the seasonal high is often in August/September, but it is. That is why the summer months often get bid up in advance when traders speculate that falling oil prices are reaching a bottom. It doesn't mean they are right, just that there will be a lot of activity around the potential peak before other months get in on the action.

Right now, this has created a steep contango.

So steep that, as you probably know already, tankers have been hired at thousands of dollars per day, to store oil which is hedged by selling futures contracts at higher prices and locking in a guaranteed profit as all costs and income are known in advance. Buy oil at $35, store it for three months for, say, $3 a barrel, and sell futures contracts for someone to buy it in three months time for, say, $42. 10% plus for a three month hold and a guaranteed profit.

Tankers did catch a bid on the back of this, but right now the day rates for a company such as Frontline FRO are near or under breakeven. Its a bad market for oil just now.

Frontline Tankers homepage:
http://www.frontline.bm/

So who is bidding up the future contracts to create the contango? What do they know?

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

Well, actually, that is to look at the situation the wrong way around. Instead of asking who is bidding up the futures, let's look at who is selling the near term oil price and depressing the near price. This creates contango by LOWER prices of oil, which seems odd at first glance.

The answer is.... da-da- all those tankers of oil sitting there waiting to be dumped onto the market - a depressant for the near term price. People can see it in the headlines - tankers full of oil waiting. Months further out expect the glut to ease so they stay more realistic whilst the near term prices collapse. Of course, economic Armageddon isn't helping either but, again, that is for another video.

Anyway, contango. It is killing USO and will continue to do so until......wait for it.... oh yes; there is a fairy godmother for USO waiting in the wings. Backwardation (where do these names come from?) - the opposite of contango - as oil supply looks to be threatened and refineries etc vie for near term oil, the price can rise above the price far out futures contracts are trading for. This was the case during the meteoric rise of oil prices to $147.

This, of course, is splendid for USO and it soars above the oil price to trade at a premium. This is because each roll out in that case buys MORE oil than the previous contract they just sold.

For example if they can sell the near term contract for $40 (Iran cut off oil supplies, tankers suddenly sink, etc) and buy the next month for $38 then the cash buys more oil - a bonus for the investors. The opposite of the current scenario. Sell at $40, buy at $38 - good for them.

For a pretty good proxy to the oil price, there is a fund called DBO which uses a mix of expiries in the futures market to track oil prices which tends to even out the contango/backwardation problem. It is a much better way to track oil and I shall post a comparison of DBO to USO in the more info section to demonstrate periods of contango and backwardation.

Is USO a pile of junk then? No, but it will exaggerate the trend in oil prices so make sure you are on the right side of the trend before looking to buy it long or sell it short.

Basically from last year traders have shorted USO as it steamed ahead on the downside. Maybe the opposite will be true on the rebound if oil recovers into an uptrend and USO benefits.

Hope that was worth your time. Thanks for listening. Bye.

Category:

Education

Tags:

• USO
• stock
• etf
• fund
• oil
• trading
• contango

[fatalegg]

thanks your da man

[flaskofcoffee]

Thanks very much indeed. I appreciate the feedback.

[mr1tomacco]

Phenominal. Just EXACTLY what I have been trying to find to explain how to play oil. I have owned USO for several years and unfortunately had a "message board" understanding of its mechanics. Warren Buffett's doctrine is to understand your investments fully or find another investment. Now I can do that honestly! Thank you.

[flaskofcoffee]

Thank you all for the kind words.

I took my own contango-beating long on USO in early 2007 so I do understand the frustration. ;-)

Really glad I could produce something of value to others.

USO is great if you keep on the right side of the trend. A bottom-fisher's dream; it ain't.

By the way; covered calls can sometimes be useful as the premium is usually high on USO.

Cheers.

[willybizz]

Excellent.

[flaskofcoffee]

Thanks, much appreciated. I am currently working on a video series about oil price manipulation and the dubious role of WTI as a pricing mechanism. My aim is to approach the subject from a practical angle - discussing ways to profit from imbalances, rather than a 'call to arms' against the system. Cheers.

[kokorugs]

Excellent video.

[fox20012]

Your at the top of my list in Google Reader, I always want to hear what you have to say, because I hope to get an insight into how these USO trading entities and the like operate

[anythingyouwant29]

Excellent explanation!

Thank you for taking the time to make this video!

[mkearns123]

OMG great video, I would love to know your thoughts on DXO vs. DBO

I'm currently in DXO but am rethinking this especially after seeing this video. However when I look at return DXO seems to perform better.