Best Of 2016: The Most Dangerous Oil ETFs

[Editor's Note: We are rerunning some of our best stories of the year.]

About six months ago, I wrote about the billions of dollars that were flowing into crude oil exchange-traded products (ETPs) like the United States Oil Fund (USO) and the VelocityShares 3X Long Crude Oil ETN (UWTI) despite the absolutely horrendous performance of these products.

"Foolish" is how I described these traders at the time. Another way we can describe them is "eternally optimistic."

Half a year later, these traders are back at it, buying USO and UWTI hand over fist on hopes they can make a quick profit if oil rebounds. So far this year, USO has seen $1.2 billion in inflows. At the same time, UWTI has seen $717 million in inflows, with $231 million of that coming on Wednesday alone.

Money Pits
That brings the inflows total for USO and UWTI since the start of 2015 to $4.2 billion and $2.4 billion, respectively. Those are monster numbers for these fairly niche commodity products, but traders have nothing to show for their bold bets—nothing but huge losses, that is.

Even with today's big bounce, crude oil is down 21.3% year-to-date. Likewise, USO lost 24.2% in that period, and UWTI plunged 62.4%. This is on top of the 46% and 92% losses for USO and UWTI, respectively, last year.

YTD Returns For Front-Month WTI Futures, USO, UWTI

These two ETPs have effectively acted like money pits, taking in billions and leaving buyers with pennies on the dollar. Aside from the fact that trying to time oil's bottom is a risky endeavor to begin with, traders are playing with fire by buying these types of products.

Undermined By Contango & Daily Rebalancing

USO, a front-month oil futures-tracking ETF, faces a substantial drag due to roll costs from contango, which consistently weighs on returns for the fund. Currently, the second-month WTI futures contract is trading at a whopping 10% premium to the front month, which is a cost that will cause severe underperformance in the ETF compared with movements in underlying oil prices.

Meanwhile, a leveraged oil exchange-traded note (ETN) like UWTI faces the same roll cost issues, as well as an additional drag from daily rebalancing.

A number of readers have emailed me asking whether it's safe to hold UWTI for several months or if there's a chance they might be able to recoup their hefty losses.

The unfortunate fact of the matter is that the ETN is unlikely to recover much of its losses, and it is certainly not "safe" to hold for an extended period of time. Leveraged products like UWTI are designed for the most aggressive traders, with extremely short holding periods.

Betting On The Wrong ETN

The irony is that traders have shown little interest in buying the oil ETPs that have been working. Inverse ETPs such as the VelocityShares 3X Inverse Crude Oil ETN (DWTI) and the DB Crude Oil Double Short ETN (DTO) saw a combined net outflow of $30 million year-to-date.

That's despite the fact that both ETNs gained more than 54% each this year on top of last year's more than 70% gains.

YTD Returns For DWTI, DTO

It looks like traders involved in these oil products would rather catch a falling knife than follow the established downtrend.

Long-term investors would do best to avoid these oil futures-linked ETFs and ETNs altogether. There are much safer ways to invest in a potential oil rebound, but for those who insist on trading these types of ETPs, just be aware of exactly what you're buying and understand how dangerous these products can be.

Contact Sumit Roy at [email protected].