I got stopped out of the short SCO today... I think the dollar is gaining value so oil is down on that... So I'm going to wait but now leaning toward UCO (USO). I trade the UCO.. not USO.. but follow both...
The United States Crude Oil ETF (NYSEArca: USO) is getting crushed right now, but if you want to know where it’s heading, it’s important to understand what it holds and what’s going on in the futures market.
USO has become investors’ proxy for oil. When you hear people talk about oil on CNBC, they’ll often mention USO. The fund has $1.8 billion in assets and trades 11 million shares per day.
As we’ve written time and again, USO doesn’t invest in crude oil or track spot crude oil prices. Rather, it invests in the front-month (or sometimes the second-month) crude oil futures contract. That can differ substantially from spot oil. For instance, while spot crude has risen more than 40 percent in the past 12 months, USO is up only 12 percent. Ouch.
Unfortunately, the discrepancy between spot crude and USO has increased substantially recently.
One reason is that “contango” in the front part of the oil futures curve has increased. Contango is a market condition when oil available for delivery tomorrow is more expensive than oil available for delivery today. That tends to hurt returns because futures by definition give you the right to purchase crude oil at some time in the future. If you’re overpaying for that right compared to current spot prices, you stand to lose money unless spot prices rise before the futures contract in question expires.
The steepness of the oil futures curve (which reflects the level of contango in the market) has increased over the past month. For example, the price of the June 2010 expiration WTI Crude Oil contract has dropped about 15 percent over the past four weeks, while the December 2010 contract has fallen less than 11 percent and the June 2011 contract has dropped less than 10 percent.
The steepening of the futures curve has hurt USO’s performance compared to alternate ETF choices. Consider the United States 12-Month Oil ETF (NYSEArca: USL). Rather than holding the front-month futures contract, USL holds equally weighted positions in each of the next 12 months’ worth of futures contracts. This tends to dampen the impact of contango, as contango is typically concentrated in the front-month futures contracts. Over the past month, USL has outperformed USO by nearly 7 percent.
Of course, the recent underperformance of USO could reverse. If the global economic outlook recovers and the front-end of the oil futures market rallies, you would expect USO to outperform USL.
And going forward, USL won’t benefit much from rising spot prices unless the entire oil futures curve shifts as well. The fund’s 8 percent position in the June 2011 oil contract, for instance, is already pricing in oil at $84.41/barrel by next summer. You could easily imagine spot oil prices rising from the current $73/barrel to $80/barrel without the June 2011 contract moving at all.
On the other hand, things could get worse for USO investors if storage trends persist. According to the U.S. Department of Energy (hat tip: Financial Times), oil inventories at Cushing, Okla. (the settlement site for crude oil futures) have risen for eight weeks in a row and now stand at 37 million barrels, the highest level ever. Cushing’s operable capacity is only 41-42 million barrels, according to the FT. If we hit capacity at Cushing, that could force spot sales, driving down the price of front-month contracts and causing a further dip in funds like USO.
USO: Not Front-Month Today
One more caveat is worth noting: USO currently doesn’t own the front-month oil contract. The fund rolled from the June 2010 contract to the July 2010 contract earlier this week. This can further increase the difference between spot crude’s performance and the performance of USO.
As of 1:30 p.m. EDT Friday, for instance, the June WTI contract was trading at $71.82 and was down 3.59 percent on the day. The July contract was trading at $75.94, 4.01 percent lower. USO should track closer to the July contract, as that’s what it holds in its portfolio.
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