Hat tip to Abnormal Returns which draws attention to this oil post on Market Folly.com.
The Market Folly piece highlights why retail investors should most definitely be interested in the forward oil curve, and specifically whether it is in contango or not. As the post explains, the performance of a fund like the US oil fund (USO) is largely dependent on three variables: 1) changes in the spot price of crude oil, 2) interest income on un-invested cash, and 3) the ‘roll yield’.
While the first two are easily understood by the retail investor, the roll yield is more troubling. Of course, when the market is in contango an index investor can lose irrespective of whether price moves at “face value” appear favourable. As you have to pay a premium to move into the ensuing monthly contract, a profit can only be achieved if the positive price moves are greater than the losses generated by the roll itself (the premium paid to remain in the position).
So while to many retail investors the low price of oil may look like an attractive buying opportunity, the current state of the market means, more than likely, they will generate a loss just because of the roll.
Consequently, a fund like the USO is not a good proxy for an oil-price position. As the Market Folly post explains (our emphasis):
The conclusion, at this stage of analysis, is that USO is not a direct play on the spot price of crude oil – it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (the slop of the futures curve). For a trader who is long USO, my instinct is that maintenance or aggravation of the contango in crude oil will cause impairment of the value of USO in relation to spot crude – whereas, any mitigation of the contango situation (including a shift to a flatter curve or backwardation) will enhance the performance of USO. I plan to study this issue more extensively. But, in the mean time, I will not consider USO to be a good proxy for the spot price of crude oil - and I will be particularly leery of participating in USO for anything other than a short term trade.”
And yet, investment in USO continues to grow. As Olivier Jakob at Petromatrix explained just a few weeks ago:
The size of investment in the ETF has recently grown to such a high level that it will need to roll in one day more than the GSCI in two days; and we do not think that the managers of the USO have the practical experience of rolling such a large position. Given the high Cushing stocks, the USO roll tomorrow to be followed by the GSCI roll and 2009 rebalancing, we would favor having any WTI length on March rather than Feb.
Interpretation? Retail investors are clearly not understanding the contango.
What’s more investors in the USO fund are potentially being doubly hurt; not only is the fund already faced with an uphill struggle of rolling a sizable position into a contango curve, it has chosen to do so all in one day with everyone knowing exactly the day it is doing so. That is not a good position for investors. To compare, both the S&P GSCI and recently UBS-taken-over AIG index roll over a number of days.
While Tuesday’s Nymex WTI roll from the February to the March contract may have seen the contango flatten a touch, it is still significant. Anyone interested can track it here on the Nymex website.
Related links:
Energy forward curves are tricky for Bloomberg – FT Alphaville
How contango affects crude oil ETFs – Market Folly