USO: Death by a Thousand Contangos
Source: Seeking Alpha, Milan Momirov (2/24/09)
". . .while USO is a useful short-term oil proxy, it should not be used as a long-term proxy without some strategy to minimize value erosion through contango. . ."
USO holds all its funds in next-month WTI futures. For example, USO started out February fully invested in the March WTI contract. Midway through February USO rolled all its funds into the April contract. The rollover has all been done on a single day, but USO recently decided to rollover over a multi-day period to minimize market impact.
When oil is in contango, far months are more expensive than near months so USO's rollover loses money. The loss is mitigated somewhat by the interest USO earns on its funds (only 10% of funds are needed to secure a contract). Also when oil is in backwardation the rollover makes money.
However, over USO's history, oil has been in contango more often than backwardation. Consequently, over its history, USO has lost value relative to oil. The ratio of one USO share to the price of crude was 1.0 when USO was launched. Today the ratio is 0.68. It's essential to appreciate that this process has NO intrinsic lower limit: a prolonged period of contango can drive USO down indefinitely even while spot oil remains unchanged.
Anyone considering a buy/hold strategy for USO today should be aware that oil has been in very steep contango and likely will remain thus for some months to come. This has been very costly to USO in recent months as a comparison of crude prices to USO readily shows.
In summary, while USO is a useful short-term oil proxy, it should not be used as a long-term proxy without some strategy to minimize value erosion through contango, such as writing monthly covered calls.