One of the best trades of the past 12 months has been an oil short. And no wonder. The price of West Texas Intermediate (WTI) crude, the benchmark U.S. grade, has been more than halved since August 2014.
Holders of the United States Oil Fund (NYSE Arca: USO), an ETF that tracks the price of the front-month WTI futures contract, felt the pain of the oil selloff in spades. USO’s 12-month loss was, in fact, five percent greater than WTI’s.
Why? In a word, contango.
Contango describes a price relationship in the futures market where near-term deliveries are cheaper than contracts calling for delivery in later months. If, for example, crude oil for September delivery trades for $45 a barrel while October futures change hands at $46 a barrel, there’s a $1 contango. Contangos reflect the cost of carrying the commodity – storage, insurance and financing costs – from one month to the next. For a storable commodity like oil, a contango tends to exist when supplies are abundant. Thus, the greater the slack in demand, the greater the price spread.
Contango is a bugaboo for commodity fund manufacturers like USO’s sponsor. To maintain constant front-month exposure, USO is obliged to “roll” its long position forward as near-term futures approach expiration. In a contango, that means USO sells low-priced expiring contracts and buys the next delivery month at a higher price. Selling low and buying high is a sure-fire recipe for loss. Each time USO rolls forward in a contango, it’ll incur an incremental expense which eats into any gains earned from appreciating oil prices and magnifying bear market losses.
Fund sponsors have devised numerous rolling schemes over the past several years to mitigate contango’s effect. USO’s sponsor, in fact, launched a sister fund, the United States 12-Month Oil Fund (NYSE Arca: USL) that takes positions in the 12 upcoming futures delivery months instead of dumping all of its assets in the next-to-expire contract. Because of this averaging scheme, USL’s lost six percent less in the past 12 months than USO. You can get a sense of the oil funds’ relative performance in the chart below. You can see that USL gained (or, more appropriately, lost less) versus USO as oil demand softened.
USO now trades at the $14 level and technically looks like it’s headed for an $8 print. USL, now worth $21, seems destined to test $14. A short sale of USO looks like a good bet for a 40 percent-plus return, better than the likely 33 percent move in USL.
If you can’t risk a short sale, you have options among five inverse oil exchange-traded products offering various degrees of leverage:
| Leverage (%) | Expense (%) | Assets ($mm) | 1-Year Return (%) | |
|---|---|---|---|---|
| Proshares UltraShort Bloomberg Crude Oil (SCO) | -200 | 1.15 | 193.7 | 258.6 |
| Velocity Shares 3X Inverse Crude Oil (DWTI) | -300 | 1.35 | 184.8 | 456.7 |
| DB Crude Oil Double Short ETN (DTO) | -200 | 0.75 | 74.4 | 227.3 |
| DB Crude Oil Short ETN (SZO) | -100 | 0.75 | 35.0 | 102.8 |
| United States Short Oil (DVO) | -100 | 1.14 | 27.1 | 107.2 |
For short sellers or holders of inverse ETPs, contango’s a benefit rather than a detriment. The reason’s simple: rolling a short position forward means you’re buying back the lower-priced contract and selling the higher-priced futures. The deeper the contango, the greater the benefit.
Brad Zigler is REP./WealthManagement's Alternative Investments Editor. Previously, he was the head of marketing, research and education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.
