What Contango Means For Oil ETFs

What Contango Means For Oil ETFs

April oil futures contracts expired today, putting concepts like contango and backwardation back into focus for oil ETF investors.

Senior ETF Analyst
Reviewed by: Sumit Roy
Edited by: Sumit Roy
Today was the last day of trading for April West Texas Intermediate crude oil futures contracts. The April contracts―which traded on the CME Group's New York Mercantile Exchange―will be replaced by the May contracts as the front-month starting on Tuesday.

Anyone holding the April contracts beyond today will have to take physical delivery of 1,000 barrels of light, sweet crude oil per contract next month. For some commercial traders with the ability to store thousands of barrels of oil at Cushing, Oklahoma―the delivery point for Nymex-traded crude―that may be something that makes sense.

But for most traders, taking physical delivery is simply impractical, if not impossible. That's particularly true for futures-based oil ETFs such as the United States Oil Fund (USO | B-100).

The Roll

Exchange-traded funds like USO are designed to track the price of oil by holding futures contracts. However, because all futures contracts expire, the ETFs must actively roll from one contract to the next to avoid taking physical delivery of thousands of barrels of crude.

USO holds front month-oil contracts, and thus must roll over its contracts each month. The fund held contracts for April delivery up until two weeks ago, after which, it rolled into the futures contracts for May delivery over a four-day period.

In the roll period between March 7 and March 10, April contracts averaged $37.64, while May contracts averaged $39.43. This situation—when contracts for future delivery are priced higher in subsequent months—is called contango, and resulted in USO holding fewer contracts after the roll than it did before (the opposite situation is called backwardation).

Over time, this "roll cost" adds up as a drag on returns for holders of USO. Just this latest one-month roll from April to May contracts resulted in the fund holding 4.8% fewer contracts. Annualize that and it's a whopping 75% cost.

Indeed, since the start of the year, front-month crude oil is up 8.3%, while USO is down 4.5%―a reflection of the roll costs from contango.

YTD Returns For Front-Month Crude Oil Futures & USO

UWTI Impacted

For holders of USO to make money, front-month oil prices—which rallied nearly 50% from their January lows—will have to keep powering higher to offset this notable drag from contango. If prices simply stand still, contango ensures that the fund will decline over time.

Of course, this situation isn't limited to USO and extends to all futures-based commodity products. That includes the VelocityShares 3X Long Crude Oil ETN (UWTI). UWTI provides leveraged exposure to the S&P GSCI Crude Oil Index―an index that tracks front-month oil futures.

As a triple-leveraged exchange-traded note, contango has an even more pronounced effect on the returns for UWTI. The ETN is down 30.5% year-to-date.

Alternatives In DBO & USL

Given the ill-effects of contango, a few ETFs have come up with strategies to try and mitigate them. The PowerShares DB Oil ETF (DBO | D-59) attempts to optimize its contract selection based on the shape of the futures curve to minimize contango.

However, the strategy isn't working so well this year; DBO is down 11.7%, much more than the aforementioned USO.

The United States 12 Month Oil Fund (USL | B-40) takes a different tack by holding 12 different futures contracts. Each month, the fund must only roll one-twelfth of its portfolio rather than its entire portfolio, like USO, which has the effect of reducing roll costs.

Year-to-date, USL handily outperformed its counterparts, with a gain of 0.2% compared with losses for most other oil ETFs.

YTD Returns For Front-Month Crude Oil Futures, USO, DBO, USL

Contact Sumit Roy at [email protected].

Sumit Roy is the senior ETF analyst for etf.com, where he has worked for 13 years. He creates a variety of content for the platform, including news articles, analysis pieces, videos and podcasts.

Before joining etf.com, Sumit was the managing editor and commodities analyst for Hard Assets Investor. In those roles, he was responsible for most of the operations of HAI, a website dedicated to education about commodities investing.

Though he still closely follows the commodities beat, Sumit covers a much broader assortment of topics for etf.com, with a particular focus on stock and bond exchange-traded funds.

He is the host of etf.com’s Talk ETFs, a popular video series that features weekly interviews with thought leaders in the ETF industry. Sumit is also co-host of Exchange Traded Fridays, etf.com’s weekly podcast series.

He lives in the San Francisco Bay Area, where he enjoys climbing the city’s steep hills, playing chess and snowboarding in Lake Tahoe.