USO Getting Crushed, But Understand Why

May 14, 2010

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.


WTI Oil Futures Curve: May 14, 2010


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.


USL vs. USO 4/11/10 - 5/11/10


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.


Find your next ETF

Reset All