All Crude Oil Is Similar, But Crude Oil ETFs Are Not

You may have noticed that crude oil prices plunged over the last few weeks. On May 3, the June crude oil futures peaked at more than $87. Then on Monday, May 17 the same contract slipped below $70. That’s a decline of about 20 percent in only ten market days!

Of course we could go back in history and point to some periods when oil prices went up just as quickly. What this illustrates is that — like many commodities — crude oil can be very volatile.

Most crude oil trading takes place in the futures markets.

For a trader, volatility spells opportunity. Unfortunately, very few people are able to make consistent profits trading in the futures market. The leverage is just too much for most individual investors.

Once again, ETFs to the rescue!

Several exchange-traded products allow you to bet on crude oil prices without the hassle of opening a futures account. You buy and sell them just like you would any other stock or ETF.

Here are five you can choose from:

iPath S&P GSCI Crude Oil Total Return ETN (OIL)
PowerShares DB Oil Fund (DBO)
PowerShares DB Crude Oil Long ETN (OLO)
United States 12 Month Oil Fund (USL)
United States Oil Fund (USO)

There are also several leveraged and inverse oil funds. But for now we’ll stick with these five since they are roughly comparable. All use derivatives to track various crude oil benchmarks. Unfortunately this is not a perfect science — and that sometimes leads to disappointment for investors.

For instance, consider the two-week stretch I mentioned above when oil futures fell about 20 percent. Here’s how each of the unleveraged oil-tracking ETFs and ETNs did during that period …

OIL: Down 19.6 percent
DBO: Down 17.4 percent
OLO: Down 17.5 percent
USL: Down 15.5 percent
USO: Down 18.3 percent

As you can see, the general downtrend hit all these funds, but by no means equally. The best of the four, USL, outpaced the worst, OIL, by more than four percentage points. Again, this happened over just two weeks.

What about longer time periods? Let’s look at one-year performance for 5/18/09 through 5/17/10 …

OIL: Down 2.5 percent
DBO: Up 10.6 percent
OLO: Up 10.4 percent
USL: Up 13 percent
USO: Down 3.6 percent

Clearly not all oil ETFs are the same. So it can make a big difference then which one you pick!

But Isn’t All Oil the Same?

Similar, yes. The same, no.

Oil is classified into various grades according to density (heavy vs. light) and sulphur content (sour vs. sweet). The delivery date also matters, since storing large volumes of oil is expensive. This is why oil is traded via futures contracts, which allow buyers and sellers to go with their own schedules.

Each of the oil-tracking products listed above faces a problem called “roll risk.” Say you have $100 million to invest in oil. Every time you “roll” your contracts forward to another month, you have to sell some futures contracts and buy new ones to replace them.

You may have heard the word ‘contango’ in reference to the futures market. Contango happens when the contract price for the following month (the one you are buying) is higher than the price for the current month (the one you are selling).

In other words, when the market is in contango, you’re losing money on every roll. And the longer you stay in, the more you can lose.

The price you hear on the news for crude oil is the “spot price.” But ETFs don’t track the spot price.

Depending on many different factors, the rolling activity can be costly. This is even truer if you have a large amount of money and want to maintain a constant exposure level — which is exactly what the oil ETFs and ETNs need to do.

One of the funds I named, United States 12 Month Oil Fund (USL), is explicitly designed to reduce this problem. Instead of concentrating its assets in one particular contract, it spreads them out over a 12-month period (hence the name). This helps but doesn’t completely eliminate the quandary.

I find that many investors have a hard time understanding all this. They don’t see why it is so hard to just buy crude oil and hold it for a long time …

The reality is that bulky commodities like crude oil are more than just entries in a computerized ledger. Ultimately they represent actual oil that must be produced, stored, moved around, refined, and eventually be sold to an end-user.

Unlike many of the gold ETFs, that actually buy and store gold bars in a vault, it is too costly and impractical for a crude oil ETF to do the same thing.

So what’s the answer?

I Have Three Tips For You …

First, realize that whatever oil proxy you buy will likely not be a precise match for the crude oil movements you hear about in the media. Other factors are at work. So be satisfied if you can just match the general direction and magnitude of the world oil markets.

Second, keep in mind that oil is not a buy-and-hold investment. I don’t know where it’s going in the years to come — and neither does anyone else! It can make sense as a tiny slice of a diversified portfolio, but even then you have to have a plan of action for the periods when oil prices are declining or when the roll risk is too large.

Third, take a realistic look at your own skills and objectives. Commodity trading, even with ETFs, may be tempting but it’s not for everyone. Be honest with yourself. There is no dishonor in sticking with what you know.

Best wishes,

Ron

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