Don’t Expect US Oil Fund (USO) ETF To Track Price Of Crude Perfectly

ETF’s have been hugely popular in recent years and many investors are unaware of the potential pitfalls of many of them.  There have been lots of controversy about the leveraged ETFs which deteriorate over time and can lead to huge portfolio losses.  There are also issues with the accuracy of the tracking of certain ETF’s particularly those that seek to track the price of commodities by buying and selling futures.  One such ETF is the United States Oil Fund (USO) which seeks to track the spot price of West Texas light sweet crude. 

Taipan wrote up a nice piece explaining how the USO ETF can have a difficult time tracking the price of crude accurately due to the contango effect.

Contango is the phenomenon that futures further out in time are more expensive than futures expiring in the current month. Contango is typical in crude because it costs money to store, ship and insure oil and those costs are built into prices over time. Sometimes contango gets extremely steep, with $10+ dollars in difference within a year’s time.

If the futures prices are more expensive from month to month, the USO fund may experience what is called a “negative roll yield.”

Here is what it looks like (this is a small example; the USO trades tens of thousands of futures contracts each month):

You have 10 contracts of crude oil in October that you can sell for $80 – you net $800.

You MUST buy $800 worth of the next month’s contracts, which are trading at $85; this means you can only afford to buy 9 contracts (balance goes into cash, which is invested in short-term Treasuries, which are essentially yielding NOTHING now).

Now let’s assume that crude rallies $10 to $95 (you own 9 contracts at $85).

You would make $90 (9 contracts x $10), where the month before you would have made $100 on the same price advance.

This does also mean that you would lose less if it dropped, but if the USO continues to go higher and higher and the contango gets more steep (which happens quite a bit) you will NOT make the returns you may expect!

While the roll doesn’t make you “lose” money necessarily, it may slow the rate at which the USO responds to movements in the long term in crude oil — this is the key to this article.