Investment risk
The United States Oil Fund, or USO, is an exchange-traded fund, or ETF, that is designed to track the daily price movements of West Texas Intermediate, or WTI, light, sweet crude oil. The firm’s website describes the investment objective as, “daily changes in percentage terms of its shares' NAV to reflect the daily changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in price of USO's Benchmark Oil Futures Contract, less USO's expenses.”
The ETF was doing a very good job of that until April when the oil market became very oversupplied due to much lower demand and the supply spigot not reacting fast enough. Due to the rapid fall in oil prices the fund has fallen substantially and underperformed its objective. Last Tuesday it affected a reverse 1 for 8 split, which is never a good sign for an investment.
Oil prices
The oversupply of oil is a global issue but especially in Cushing, Oklahoma, as that is where multiple pipelines and dozens of storage tanks are located. The lack of storage in Cushing led to a significant drop in oil’s price and why it went negative for a day two weeks ago when future contracts were about to expire. Investors who had long positions in the contract that was expiring and have no capability to take delivery of the commodity had to pay others to close their contract.
Oil storage
A brief overview of the futures markets
The futures market is considered to be in “contango” when the spot or current price is lower than the futures price, which generates an upward sloping price curve. Physically delivered futures contracts, such as oil, may be in contango because of fundamental factors like storage, financing “inventory” and insurance costs.
Backwardation is when the spot or current price of a commodity is higher than the futures price and the price curve is downward sloping. The slope can change from contango to backwardation or vice versa depending on market conditions.
A key aspect of the futures market is that if an investor does not close out their position the day before the contract expires they have to take position of the commodity.
Investors, especially retail investors, have flooded into the ETF as a way to buy into commodities and planning/hoping that oil prices will rise. Unfortunately this has not been the case.
As Michael O’Rourke at JonesTrading (no relation to me) wrote on April 21, “The most remarkable aspect of this episode is that the speculators at the heart of this dislocation are the retail public as they sought to wager on oil prices through the USO ETF. Although retail is not directly responsible for yesterday’s negative prices, they represent a remarkably outsized group of speculative longs who have no capability to take physical delivery.” The chart below shows how much USO’s contracts dominated the market two weeks ago and helped lead to the negative pricing of oil for a day.
USO market cap as a percent of WTI 2 forward months contracts
An example of contango is the current pricing of WTI future contracts
On Sunday these were the prices per barrel of WTI through December. As you can see each future month has a higher price associated with it vs. the prior month.
- June: $19.78
- July: $22.29
- August: $24.20
- September: $25.69
- October: $26.79
- November: $27.74
- December: $28.59
USO provided this example about contango and its impact on the ETF
Katie Rooney, USO’s Chief Marketing Officer, provided this explanation and example on how contango and backwardation impacts the ETF’s returns.
She wrote, “Contango creates a drag on returns, but the effect is gradual and variable. Losses occur over time, not at the point of the roll. For example, assume a commodity is $50, the front month future that commodity is also $50 and the second month future is $51. If a fund has $1 million invested in the front month future at $50 and rolls to the second month future at $51, the fund will still have $1 million invested in that commodity. No loss has occurred.”
Rooney added, “However, futures prices converge to spot as they approach expiration. So if underlying commodity prices remain flat, then the $51 future will decline to $50 over the course of the month. This would result in a 2% loss over the course of that month (bought at $51, sold at $50). If these dynamics remain in place the next month, then the same thing occurs again.” She provided this example.
- An investor who holds this position for six months would have about a 6% loss
- If the contango remains stable but the underlying commodity rises 10%, then the investor’s return would be about 4%
- And if the commodity was in backwardation at a rate of about 2% per month and the underlying commodity rises 10%, then the investor’s return would be about 16%
Lastly, “Of course, the above is a simplified example. Underlying commodity prices do change, and the level of contango (or backwardation) changes. Contango does not mean an investor will have a negative return, and backwardation does not guarantee a positive return. These forces serve as a headwind or tailwind respectively.“
Oil price
Over 10 days USO changed which contracts it invests
Starting on April 17 USO started a series of rapid changes in which future contracts it would be investing. Where the ETF had been 100% invested in the closest month’s contract it started to diversify among multiple months.
April 17, Friday
- approximately 80% in the front month contract
- approximately 20% in the second month contract
- except when the front month contract is within two weeks of expiration, in which case the futures contracts held by USO will be rolled into the second month contract and third month contract.
April 21, Tuesday
- approximately 40% in the June contract
- approximately 55% in the July contract
- approximately 5% in the August contract
- except when the front month contract is within two weeks of expiration, in which case the futures contracts held by USO will be rolled into the July contract, August contract and September contract.
April 22, Wednesday
- approximately 20% in the June contract
- approximately 50% in the July contract
- approximately 20% in the August contract
- approximately 10% in the September contract
April 24, Friday
- approximately 20% in the June contract
- approximately 40% in the July contract
- approximately 20% in the August contract
- approximately 20% in the September contract
April 27, Monday
- approximately 30% in the July contract
- approximately 15% in the August contract
- approximately 15% in the September contract
- approximately 15% in the October contract
- approximately 15% in the December contract
- approximately 10% in the June 2021 contract
USO has underperformed over multiple timeframes
StockCharts.com has a feature that allows investors to compare investments. Starting with a one-month to 10-year timeframes USO has underperformed in every one. Both USO and WTI have also substantially underperformed the S&P 500 Index. It appears that they typically only outperformed the stock market over short timeframes when stocks had large, sharp declines.
- One month: USO down 46%, WTI down 3% (S&P 500 up 15%)
- Three months: USO down 79%, WTI down 62% (S&P 500 down 14%)
- Six months: USO down 79%, WTI down 63% (S&P 500 down 7%)
- One year: USO down 82%, WTI down 69% (S&P 500 down 3%)
- Three year: USO down 77%, WTI down 60% (S&P 500 up 19%)
- Five year: USO down 89%, WTI down 67% (S&P 500 up 36%)
- Ten years: USO down 94%, WTI down 7% (S&P 500 up 135%)
3 year prices for USO ETF, WTI and S&P 500
BUT over the past three years the underperformance was all created in April
However, when April and May 1 are excluded from the analysis, USO’s performance has been right in-line with WTI’s. Both USO and WTI have still underperformed the S&P 500 Index.
- April and May 1: USO down 44%, WTI down 3% (S&P 500 up 10%)
- February and March 2020: USO down 61.1%, WTI down 60.3% (S&P 500 down 20%)
- November 2019 to March 2020: USO down 64.0%, WTI down 63.6% (S&P 500 down 16%)
- May 2019 to March 2020: USO down 68.2%, WTI down 67.8% (S&P 500 down 12%)
- May 2017 to March 2020: USO down 58.5%, WTI down 58.1% (S&P 500 up 8%)
3 years minus April and May 1 prices for USO ETF, WTI and S&P 500
USO has underperformed in the five and ten year timeframes when April and May 1 are excluded.
- May 2012 to March 2020: USO down 79%, WTI down 65% (S&P 500 up 23%)
May 2010 to March 2010: USO down 90%, WTI down 76% (S&P 500 up 112%)
