Imagine a scenario where you were anticipating a rebound in crude oil prices. From the start of 2014 through the beginning of 2016, a barrel of WTI crude oil dropped from nearly $110 at its peak all the way down to below $30. The bad times can’t last forever, you say to yourself, and decide that oil prices are bound to rise again.
The easiest way to get exposure to crude oil prices, you say, is through the United States Oil ETF (NYSE:USO) and decide to buy some shares at the beginning of 2016.
Fast forward to the present and the price of oil has rebounded although not to a significant degree. It started the year at around $37 and now trades north of $43, a gain of nearly 17% year-to-date. You feel proud that your prognostication has come true and decide to check out your brokerage statement to see how much you’ve made on your U.S. Oil ETF trade. You log in and see that the fund is…down 4%!
How can the price of a barrel of crude be up 17% but the price of the crude oil ETF be down 4%? Welcome to the wonderful world of trading in the futures markets!
So why the huge disparity in performance? The answer is that the U.S. Oil ETF isn’t buying physical oil. It’s buying oil futures contracts. Unlike stocks which can be purchased and held indefinitely, future contracts expire on a monthly basis. The U.S. Oil ETF holds on to these futures contracts up until just prior to expiration when it sells its position and reinvests the proceeds into next month’s futures contracts.
The root cause of the fund’s losses is the fact that the oil futures curve is upwardly sloping. This means that the futures price of a barrel of oil is generally higher each additional month you go out into the future, a situation known as contango. Given that the fund’s contracts expire every month, it needs to continuously sell its position and reinvest at a higher cost than what was previously established. The need to regularly buy new contracts at higher prices produces what’s called a negative roll yield, a circumstance that can cost holders a lot of money every time the trade is made.
We see the same thing happening in the volatility markets where the CBOE S&P 500 Volatility Index is down 34% year-to-date but the iPath S&P 500 VIX Short Term Futures ETN (NYSE:VXX) is down 58%. The United States 12 Month Oil ETF (NYSE:USL) attempts to address the contango problem by spreading its exposure across 12 months of futures contracts instead of one. Up 6% on the year, it’s done better than the U.S. Oil ETF but still lags the price gains in crude oil significantly.
This phenomenon is perhaps the biggest danger of owning ETFs that trade in commodities or utilize leverage (which is obtained through the use of futures contracts). Over time, the carrying cost of maintaining these positions will usually prove too prohibitive regardless of which side of the trade you may be on. At this point, any ETF that deals with futures contracts in a contango market is probably best left alone.
He has written for Seeking Alpha, Motley Fool, ETF Trends and Investopedia and was also included in the panel for ETFReference.com’s “101 ETF Investing Tips from the Experts”. He has a B.A. in Finance from Michigan State University and lives in Wisconsin with his wife and two daughters.