Oil: One Thing ETFs Just Can’t Get (Contangos)
Commodities have long been a difficult underlying index to track, but the proof is in the pudding. The spot price for oil has surged in value by more than 54% this year, so why are two exchange-traded funds lagging so far behind?
Cracking the ETF Numbers
Year to date oil has racked up an impressed 54% gain but the two largest exchange-traded funds in oil are still behind. U.S. Oil Fund (USO) and U.S. 12 Month Oil Fund (USL) are up just 8 and 22% respectively. The difference is horrifying, but what we have uncovered is a discrepancy that is present in virtually every exchange-traded fund backed by futures.
Oil ETFs and Contango
When you speak to oil futures traders the most dreaded word is the contango. A contango is when the price of a longer date contract is higher than the front month contract. For exchange-traded funds the difference is even more deadly. Lets assume we own an exchange-traded fund that owns 100 barrels of oil at $65 per barrel, and the next month contract is $66.30, a 2% difference. (A 2% differential is a relatively small contango) When we go to roll over our contracts, we sell the 100 barrels on the current month for $6500 and have to roll them over into the next month. The problem is we can now only buy 98 barrels. In due time, the price will come down, as with any premium (think options) but we need the oil NOW not later.
A Hidden Fee
A contango is basically a hidden fee that investors never see deducted from their account. Many investors, I fear, are losing more money per year than they imagine, due mostly to the different prices for futures contracts. If your account draws down by 2% each and every month, by the end of the year you would own 22% less of a product than you did before. No wonder why oil ETFs are lagging so far behind!
The Solution
Exchange-traded funds are popular for two reasons. 1. They appear inexpensive. 2. They are convenient. I hate to break it to you but inexpensive and convenient never go hand in hand. Owning any commodity outright through exchange-traded funds backed by futures should be a huge no-no. Instead, look to buy stocks that deal directly in the commodity either in production, mineral rights, or refining of the product. These companies typically rise and fall at a rate much more comparable to the spot price of the commodity than any exchange-traded fund.
Yeah, I was looking at commodities as a hedge against inflation recently. I looked at ENER, PCX, HTE, TRMD, PVA, and X. I didn’t want to own the commodities outright because of ease issues, and the ETFs I saw looked like they were underperforming the commodity prices I was looking at. Also all these companies were super beat up…