Why you should never buy oil ETFs

Commodity ETFs (exchange-traded funds) such as the United States Oil Fund (USO) aims to track the performance of oil. They’re supposed to be a cheap and fast way to gain access to oil exposure for retail investors. However, this does not mean the fund actually holds any physical oil.

Recently, there has been a lot of interest among retail investors to get back into oil. What better way to get oil exposure than to buy an oil ETF?

Wrong.

USO (and its levered counterpart UCO) do not hold physical barrels of oil. Instead, they hold oil futures contracts.

What is a futures contract?

It’s simply a contract that promises the holder to buy the oil at a later date.

But futures contracts expire. And when they do, they force the holder to make good — i.e., if you’ve brought a futures contract, on expiry, you have to settle the contract and buy those barrels of physical oil like you said you would.

Obviously, USO, run by an asset management house, is not going to send their MBA graduate analyst out there to Oklahoma to receive the oil. And hence, they sell out of the futures contract just before expiry and then buy another batch of futures contracts that haven’t yet expired. This is called “rolling your futures”. (Just like how supermarkets roll over their stock)

The roll is not cheap.

The market anticipates a flurry of selling before futures expiry. This selling pressure causes the futures price to be sometimes very low. Remember the time in April where oil became negative?

The prices of futures contracts that are not expiring soon are usually priced higher than the underlying spot. This is called contango — where futures price exceeds spot price.

Sometimes you hear people on the internet say contango is a bullish signal — because hey, the future price is greater than the spot price. That’s not actually the case. So long as interest rates are positive, the futures price should be slightly higher than the spot price. Futures price = Spot price * Adjustment for interest rates.

Therefore, normally Futures price > Spot price. And of course, if there is any bullish sentiment, it will be even higher. This discrepancy decreases as the futures contracts come closer to expiry.

In short, USO sells on the low and buys on the high.

Shouldn’t we be buying on the high and selling on the low? If oil market eventually rebounds, USO will not rebound as high due to contango.

Over the long run, contango can be costly. These futures-based ETFs are only good for very short term tactical plays, not long term investment exposure.