The United States Oil Fund ETF (USO) and Contango

While the word contango doesn’t typically roll off the tongues of most retail investors, it can have an impact on some of the products retail traders may invest in.

Contango relates to the futures markets specifically and basically means the forward curve or future price of that commodity is positive.  This is considered a “normal” situation, especially for futures on commodities (such as oil) that have a cost to carry.  Oil costs money to store, ship, insure, etc.  All of these factors contribute to the future price of oil being higher than today’s spot price.

When you think about it, if a trader were to buy oil at the spot price today and store it and insure it for delivery at a future date, that future price should reflect those costs. This is why it is a normal occurrence to see the contango phenomenon in the oil futures markets.   One of the more popular ETFs that tracks the price of oil is the United States Oil Fund, ticker symbol USO, which is traded on the NYSE.

The USO actually holds (purchases) futures contracts in WTI (West Texas intermediate crude oil).  The investment objectives set out by the fund itself state that it will hold only front-month futures contracts and roll those contracts forward each month on a stated date.  Rolling, in this case, means to sell your front-month contract position then simultaneously purchase futures contracts the next month out.  Where this can be a detriment is when there is a steep curve or contango in futures contracts.

Here is a simple way to think about it.

• Assume you owned 100 May oil contracts that are trading at $80; the value of your investment is $8,000.

• You sell your May contracts at $80 and buy June contracts (trading at $85.00) with your $8000; this means you can only afford to buy 94 June contracts for $7,990 (excluding commissions). You might then put the remaining $10 in a short-term U.S. Treasury investment (this is what the USO does).

• Now suppose oil goes to $100, an increase of $15 for the June contracts. Instead of having 100 contracts, you now only have 94 contracts. Because of the “roll” to the June series, you will make $1,410 versus $1,600 if you owned the original 100 shares at $80. This does also mean you would lose less if oil drops.

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.

Some traders may become frustrated that their investment in USO did not grow as fast as the underlying futures contracts. The lesson here is that you must always research and understand the nuances of the products you invest in, as it may not just be the fees that could potentially cost you money.

Photo credit: ezioman

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