The Future of US Oil – An analysis of USO
Dominic Byrne | June 18th 2020 | Editor: Eden Chan
The United States Oil Fund (USO) is an exchange-traded product (ETP) that aims to tracks the daily price movements of the West Texas Intermediate (WTI) light, sweet crude oil. USO experiences a futures market phenom known as contango. Contango is the situation when future prices of an asset are expected to be higher than current prices such that the spot price is lower than the futures price. This, in turn, depreciates the fund at a slow rate each month. A premium known as the ‘cost of carry’ is also paid on top of the futures contract for the storage and potential spoilage of the asset. Therefore, the United States Oil Fund may be a good investment for a bullish outlook in the short-term. Still, long-term investors must be wary of the effects of negative roll yield and contango when considering USO.
The Funds Investment Strategy:
The investment objectives set out by the fund itself states that they hold only front-month futures contracts and roll these forward each month, until recently. This means selling the front-month contracts and purchasing contracts for the next month out. This has detrimental effects on the stock itself when a steep curve or contango occurs in the market. However, the fund recently announced a new strategy involving the purchasing of dated contracts a year away. 25% of the current portfolio is now made up of contracts expiring in 6 months (i.e. December 2020) which exposes the market to expected oil movements.
An Explanation of Contango and what it means for investors:
Suppose USO owned 100 may oil contracts trading at $80 – valued at $8000.
They would then sell the contacts and purchase June contracts – trading for $85.
In doing this, the company now can only purchase 94 June contracts for $7990, excluding any commissions. The remaining $10 is then put into short-term Treasury investments as USO does.
Because of this rollover, losses and profits are slowed. Therefore, the fund is not equivalent in its correspondence to changing WTI crude oil spot prices daily. This can lead to frustration when investors discover that their USO shares do not grow at the same rate at which the underlying contracts grow.
Recently, the fund began to change how it operated to negate the contango associated with forward dated options by exposing itself to dated contracts expiring in late 2020 and even 2021. This restructuring may mean that a lot of the current fund price is associated with market pessimism and optimism, which opens opportunities for long term investors who are seeking exposure to a bull oil fund.
As a short-term investment, The United States Oil Fund is a fantastic opportunity for portfolio growth and profit in a bullish market. However, the negative roll-yield caused by contango locks in losses and cause damage to a portfolio if not managed correctly. Although he funds recently changed its investment style and portfolio holdings, this still exposes the fund to contango and its negative effects for longer investments. Their restructuring, however, may have made the fund easier to justify investing for long-term investors. The fund was designed for those who regularly monitor their portfolios and intend on short-term plays. If you want to invest in USO in the short-term, it has a positive in this volatile market. USO is one of the largest oil ETPs with over $300 million in daily trading volume and $1.6 billion in Net Assets. An exit strategy from this share is relatively straight-forward – but ensure you know when you intend to cut profits or losses, as long-term holding is not ideal.
After the stock fell 30% in April to just above $2 per share, halting new trades, allowing structural changes to occur to avoid a complete collapse of the share. USO’s 1-8 reverse stock split, recognised at market close on April 28th, 2020, caused eight shares to become 1. They are essentially reducing the number of shares available in the market. Reverse stock-splits do not affect the value of a company but may be a sign of distress as the company is raising the price of low-value shares.
No one can tell for certain the future movements of oil. Even if you could, I wouldn’t recommend USO as an ETF to invest in. The lagging movements, negative-roll yield and contango makes this fund particularly tricky to invest and ‘time’. Daily changes in recent years have not matched price movements of USO. For this reason, unless you are confident of the futures market, USO may not be a good investment in the future.
Published by Koki Mashita
Written for Lallic Partners