The Hidden Leverage of Oil ETFs

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"If oil rallies, we should see the substantial contango switch to backwardation and deliver strong performance to those owning USO."

Financial innovation drives markets. Over the years, we have seen investments that had been the sole province of professionals adapted for retail investors. Among the more popular have been inverse ETFs and commodity-based ETFs.

These new tools may be welcome, but we must watch for unintended consequences. I previously discussed the difficulties of using inverse ETFS as a long-term investment. This past weekend, I read an in-depth piece on the oil ETFs and began examining their uses. As with most financial innovations, a grasp of the details is needed to make sure gains do not turn to losses.

I have used the U.S. Oil Fund (USO) as a way to speculate on the price of oil. Most would expect USO's performance to mirror that of oil. Although the direction of the two is similar, changes in the term structure of oil also impact USO's performance.

Understanding the nature of the futures market is essential to properly utilizing USO. As with other commodities, oil trades for delivery at many different dates. If the price of oil today is higher than the price one month from now, the markets are in backwardation. If the opposite occurs and oil is more expensive in future months, the markets are in contango.

Because USO purchases futures contracts at various points along the curve, the term structure has a material effect on performance. Consider a market where the current-month future contract is $30 and the one-month forward contract is $27. As the current-month contract approaches expiration, USO will sell it for $30 and purchase the next month for $27. Doing so earns a positive roll of $3 and increases performance. This would cause USO to outperform when the market is in backwardation and lag when the market is in contango.

Generally, markets in backwardation are bullish, while those in contango are bearish. Knowing that a shift in term structure affects performance, investors buying and selling USO are not only expressing their view of the direction of the markets, but the term structure as well. This nuance serves as a source of leverage that will allow you to maximize gains in losses.

If you are bullish on oil, today's market is ideal. If oil rallies, we should see the substantial contango switch to backwardation and deliver strong performance to those owning USO. If you believe the contango will continue to widen as oil prices decline, a short position will offer extra return. This nuance is key to using USO as an effective portfolio tool. Innovation opens this market to the masses, but we must remain informed to ensure that we are using the products correctly.

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