How to Play a Bounce in Oil (Hint: Not $USO)

It’s the first (real) week back from holiday break, but the story is the same as it was before Christmas, and before Thanksgiving for that matter…. Crude Oil continues to fall like a lead oil filled balloon, falling below the $50 mark on Monday for the first time since 2009. It’s even gotten to the point of family and friends asking where we think Crude Oil will bottom at parties and dinners, getting our contrarian antennas perked up.

The million, or actually Trillion, dollar question is where will Crude finally find a bottom and bounce back?  Fortune let us know recently that the $55 drop in Brent Oil prices represents about a Trillion dollars in annual savings.

Now, while some are no doubt betting on continued downside with the recent belles of the ball – the inverse oil ETFs and ETNs ($DTO) ($SCO) ($DWTI), the last of which is up a smooth 527% since July {past performance is not necessarily indicative of future results}. Others are no doubt positioning for the inevitable rebound in energy prices, thinking it is just a matter of when, not if. Crude Oil is back around $70 to $100 a barrel. And what a trade that would be. Consider a move back to just $75 a barrel, the very low end of where Crude spent the last 5 years, would be a 50% return from the current $50 level. It seems like that could happen nearly overnight without anyone really thinking much about it.

So how do you play a bounce in Oil?

Well, the most popular play, by size and volume ($1.2 Billion in Assets, $387 million changing hands daily), is no doubt the Oil ETF ($USO). But is that really the best way to ‘play’ a bounce?

Consider that $USO Is designed to track the “daily” movement of oil.  What’s the matter with that? One would hope that the ETF closely matches the daily move of Oil, right? Well, yes and no. Yes if you are going to buy the ETF for one day, or even a couple of days; no if your investment thesis is oil prices will climb higher over an extended period of time. Because, and here’s where it gets tricky – $USO’s long term price appreciation won’t match the sum of its daily price appreciations. What?^%$  How is that possible?

You see, the ETF works by buying futures contracts on Oil, and there are 12 different contracts in Crude Oil futures each year, you guessed it – one for every month. And while the so called ‘front month contract’ is trading near the number you see on the news every night ($50 yesterday), the further out contracts, such as 10 to 12 months from now, may already reflect the idea that Oil prices will be higher.

4 Hedge Fund Whitepaper Crude Oil Banner

Indeed, the price for the December 2015 contract is $57, versus $50 for the front month. So there’s $7, or a 14% gain, already “built in” to the futures price. What’s that mean for the ETF investor?  Well, if you are correct that Oil will rebound, and it does so, to the tune of rising 14%, or $7 per barrel, over the next 11 months; the ETF likely won’t appreciate 14% as well. It likely won’t move at all, because it will have to sell out of its expiring futures positions and buy new futures positions each month. This means it will essentially have to “pay” that $7 in what’s called “roll costs”.

This is why $USO has drastically underperformed the “spot price” of Oil over the past five years, with $USO having lost -39% while the spot price of Oil went UP 48%. It is like an option or insurance premium – a declining asset with all else held equal. Just look at what happened during the last big rally for energy prices between January 2009 and May 2011. That’s a 110% difference between what you thought was going to happen and what the ETF rewarded you with.

Crude Oil(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Barchart

So if you think Oil will be higher 3 months from now, or 12 months from now, instead of tomorrow, the United States Oil Fund ($USO) is at best going to give you some discounted version of your expected gain, and at worse a possible loss when Oil gains. (PS, the 2x version $UCO will do all this, times two… yeah) You don’t even have to take our word for it. Take the description of the USO over at ETF.com.

“ USO is a great vehicle for riding short-term moves in expected crude prices, but longer-term holders take on heavy roll risk. Roll costs can be steep when the curve is up-sloping.”

Ok – so don’t offer a problem without a solution… What other options are out there?

Well, in our realm of futures based investments, you could:

  • Trade futures in Crude Oil, Heating Oil, RBOB Gasoline that match your time frame for a rise in prices; rolling them once annually if needed, as we’ve recommended instead of commodity ETFs for some time now. For example, if you think Crude Oil will be higher 12 to 18 months from now, buy the June 2016 Crude Oil futures (currently  It will still underperform the pure spot price, but will only pay that roll cost once per year instead of multiple times).
  • Invest with an energy focused professional commodity trading advisor, we have some names.
  • Invest with a trend following manager – who should benefit from a long term trend up (just as they are benefitting from the trend down right now {past performance is not necessarily indicative of future results}, albeit the energy portion would only be a small portion (<5%) of their overall portfolio.
  • Buy the incredibly thinly traded Russian Ruble futures on hopes an energy rebound brings Russia, and its currency, along with it.
  • Sell Oil future Puts at or below the current market price, getting paid for the willingness to buy at these levels.
  • Do some crazy Bull Call Spread trade, being cognizant of the fact you’ll have to get the price and time right.

Outside of our realm, here’s what came to mind…

  • Buy the energy industry ETF, $XLE, just be aware that energy companies have a lot of things going on that don’t relate to energy prices (debt, shareholders, employees, lawsuits, spilling oil, regulations), and don’t use it to hedge against inflation as this guy suggested instead of managed futures…
  • Buy the 3x energy sector ETF, $ERX – with three times the issues listed above.
  • Try to catch the falling knife which is Venezuelan Bonds
  • Sell credit default swaps on the high yield debt offered by fracking industry players… although you probably have to be a hedge fund guy or Goldman Sachs partner to do that.
  • Offer to cover the Harold Hamm’s $1 Billion Alimony payment, in exchange for 10% of his future net worth gains.
  • Buy a whole tanker truck full of unleaded gas, or two or three, and put it in back yard and fill up for next couple years at under $2.00 !  It’s only about 10,000 gallons * $2 = $20,000. Get a few people on your block to chip in… just keep the kids away from the contaminated dirt after a few months.
  • Buy $TSLA stock, it’s been getting hammered (down about -26%) along with Oil prices, behind the logic that people won’t want an electric car if gas is cheaper. Maybe the weakness is due to other factors and that’s just the excuse, and that’s surely a risk – but this was our best chance to share the Oatmeal’s fantastic comic about what it’s like to own a Model S.

3 comments

  1. […] For instance, many would likely turn to the United States Oil ETF (NYSEArca: USO), which tracks West Texas Intermediate crude oil futures, to play a potential turn in the energy market. USO is the largest and most popular oil-related ETF option on the market, with .2 billion in assets and 7 million changing hands daily, according to Attain Capital. […]

  2. […] Also there are many alternative industries. For example, steel, helicopters, rare earth metals, tesla – are all connected to oil industry and serve it. You can buy the alternatives. […]

  3. I constantly spent my half an hour to read this webpage’s posts daily along with a cup of coffee.

Write a Comment

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.