Thursday, January 29, 2015

How To Profit From An Increase In Oil Prices When It Occurs

One investment vehicle that may seem appropriate for participating in an eventual rise in crude oil prices is to invest in an ETF that directly tracks crude oil itself. One such ETF is the United States Oil ETF, ticker USO. There are many others that can be found here. However, investors should be aware that many of these ETFs gain crude oil exposure using futures contracts. Consequently, the ETFs using futures will not track oil prices directly. Several key points investors should be aware of regarding ETFs and mutual funds that use futures contracts for investment exposure follows:
  • USO gains exposure to oil using futures contracts. The issue with utilizing futures contracts has to do with the shape of the futures curve for oil. In order for USO to maintain exposure to oil, the index manager must “roll forward” futures contracts for oil. If the futures curve predicts higher prices for oil in the future, this added cost to roll forward the oil contracts eats into USO’s return. As the below chart shows the WTI futures curve is in what is called contango. This means the curve is upward sloping, i.e., higher future oil prices expected by the market. As a result the USO investment loses money as contracts are rolled forward. This is known as negative roll yield. A recent article on the oil futures curve, Contango Widens, can be read on Bloomberg.
From The Blog of HORAN Capital Advisors
Source: eia

As noted in a recent Morningstar analysis for USO,
  • "in 2014 USO declined by 43%, close to WTI's spot price collapse of 46% for the year. However, in 2009 (the last time there was a sharp rebound in oil prices) USO gained 14%, while the spot price soared 78% higher [emphasis added]." The lagging performance of USO versus the price of oil is largely due due to the negative roll yield issue mentioned above.
So how can an investor benefit from an increase in crude oil prices? Below is a chart of USO, the ETF with ticker XLE and the price of West Texas Intermediate crude. As can be seen on the chart, the energy sector ETF, XLE (orange line), actually outperforms USO (red line) as energy prices began to rise in 2010 as noted by the circle on the chart.

From The Blog of HORAN Capital Advisors

In summary, if one believes oil prices will rise, investing in an ETF like XLE is likely a better way to profit from rising oil prices.


Jean-Luc Saillard said...

Didn't they address the issues with USO since 2009 so that it tracks oil prices better in these situations? I did an analysis of the oil ETFs at:

David Templeton, CFA said...

Jean-Luc Saillard,

I am not aware of a change to USO; however, there is another ETF, USL ( 12 Month Oil USL). Rather than rolling near-month futures contracts, USL ladders 12 months' worth of futures contracts in an effort to mitigate the impact of backwardation and contango.