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The Wrong Way to Profit From Crude Oil

Commodities / Crude Oil Jan 28, 2009 - 12:17 PM GMT

By: Investment_U

Commodities

Best Financial Markets Analysis ArticleYou might think you're properly invested in oil, but you could be wrong.

Despite reaching lows since 2004, the long-term outlook for oil is still up. Maybe not $147 a barrel like the old days (i.e. six months ago), but because of supply, demand, turmoil in the Middle East, and the fact that we will eventually resume worldwide economic growth, oil prices have only one way to go.


If you think you've positioned yourself according, or if you're thinking about a new investment in oil… tread carefully. Here's why:

I covered a situation last week call contango. It's a feature of futures markets where you can buy oil cheap right now and lock in a contract to sell it in the future for a higher price. Normally, the difference between those prices is so close to the cost of storing the oil that it's not a profitable trade.

But right now, we're in a state of super-contango. Prices are way out of whack. And commodity investors are storing oil everywhere they can to earn the excess profits. (For a more detailed description, see contango .)

Contango is big news now. But some of the “traditional” oil investments that are being tossed around aren't what they seem to be. In fact, if you skipped some very fine print, you could have set yourself up for a huge disappointment.

So let's clear that up… and pad our pockets with a little extra in the process.

You're Not Buying What You Think You're Buying

When we broke the news on contango, we suggested looking at some oil storage providers, explorers and drillers. And that hasn't changed. Looking around, there are a number of “oil investments” that look promising.

One would think the quickest way to invest in rising oil prices would be to simply buy shares of an oil-based ETF, like United States Oil (NYSE: USO ). These oil ETFs are very popular – USO trades over 34 million shares per day.

But not so fast.

These funds don't buy and sell oil for profit. They trade futures contracts on oil. And while there are a few ways to do that – some good, some bad – they may not be the best way to take advantage of contango. Let me explain.

USO buys a contract for oil for the very next month. Before it expires, they sell it off and buy one for the next month. In a contango situation the returns will indisputably be lower. (Conversely, during the opposite of contango, “backwardation,” the fund returns will be higher).

USO makes no secret of this. They print it in their risk disclosures that contango is not good for their fund.

And they are not alone. The iPath GSCI Crude Oil ETN (NYSE: OIL ) and the Powershares DB Crude Oil ETN (NYSE: OLO ) use the same methodologies. (Though OLO actively manages its roll forward strategy to reduce losses.)

But don't give up on investing in oil.

Every Problem Has a Solution

In fact, the same manager that runs the USO fund runs another, custom designed to benefit from situations like this. It's called the United States 12 Month Oil Fund (NYSE: USL ). It uses a 12-month average of futures prices that will lessen the losses caused by a contango market.

Here's the interesting thing. Oil markets usually exhibit a small amount of contango, it's a natural result of price fluctuations. But its opposite, backwardation, is the rarity. So even if we were in a normal oil situation, wouldn't the 12 Month Fund be better?

In fact, wouldn't it make sense all the time? It would seem to be so.

Obviously, oil prices have been down… but you'd have fared significantly better investing in USL. Reading the fine print on an ETF isn't the most entertaining way to spend your day, but it's certainly worth a near 15% difference in performance.

If we were to enter a backwardation period, USO would then outperform. But since backwardation is so rare… you can expect USL will outperform consistently over the short and long term.

Ahead of the tape,

by Matt Weinschenk , Senior Analyst, The White Cap Report

http://www.investmentu.com

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Comments

marketfolly@gmail.com
29 Jan 09, 09:59
market folly

Matt,

thanks for the article.. hadn't looked into USL before. we actually just recently posted two articles regarding ETFs/ETNs and crude oil.

how contango affects them: http://www.marketfolly.com/2009/01/how-contango-affects-crude-oil-etfs-and.html

and just a general comparison of each as a play on crude: http://www.marketfolly.com/2009/01/how-to-play-crude-oil-using-etfs-etns.html

would love any comments or follow-up. thanks


mario
31 Jan 09, 04:45
levered ETF

there are also leveraged (2x)etf like DXO, now i think it's time to buy those oil related etf and wait, we have time as our ally, contined oil production cuts will have effect ,

can u please write an article about all leveraged etf?

i mean etf on energies,softs metals with a reasonable leverage, 2x


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