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People chasing oil buying USO long term are poised for a rude awakening.

People are jumping in oil (USO) futures these days. Data shows that these buy orders are coming from retail investors (from Fidelity, TD Ameritrade, and similar accounts). People, who are jumping in USO now think that with futures at 2.50 per contract they will become rich long term when oil recovers.

But they have it wrong. Just by a nature of the USO ETF, they will lose money due to Contango effect.

What does it mean?

Let’s take a brief look how USO operates. USO buys oil futures contracts. But they do not buy them to buy physical oil. They do not want to have barrels of oil stored at their backyard. So what USO does when the contracts are nearing to expiration?

They sell the current contracts and buy next month contracts. And when next month contracts near to expiration, they sell those contracts and roll into the next month, and so on.

And now look at the current quotes of crude oil futures with different expirations.

 
USO
 

CL May contract is at $2.87
CL June contact is at $15.13
CL July contract is at $23.17

As those contracts near to expiration, USO has to sell its May contracts at $2.87 and buy June contracts at $15.13. And as June contracts near expiration, they will sell at $15.14 and buy July contracts at $23.17, and so on. This is a constant erosion of the ETF’s price. Buying USO and staying in it waiting for oil to recover and thus becoming rich is a path to destruction.





5 responses to “People chasing oil buying USO long term are poised for a rude awakening.”

  1. Justin Duncalfe says:

    I’m embarrassed to say I’m one of those people. I bought a substantial amount of shares last week what do you recommend I do? I know there’s no clear answer but any input would be much appreciated.

    • Martin says:

      Usually the least comfortable step to do is the best one. So a simple answer would be get rid of it, close the position and move on, invest into oil companies instead, but those which would likely survive this slump. Which are those? Hard to say. My opinion is those companies which pay dividends and which even increased them during this period of time.

      If you are deep under water and want not willing to close the position (I know the feeling, I have been there many times) you can utilize options and keep selling covered calls to recoup as much money as possible. But, it still may be tricky…

  2. Justin Duncalfe says:

    I’m embarrassed to say I’m one of those people.I bought a substantial amount of shares last week what do you recommend I do?I know there’s no clear answer but any input would be much appreciated.

  3. Foxy Michael says:

    Great explanation of the contango effect. Do you know if ETCs share the same fate with ETFs? For example, the WisdomTree CRUD ETC should not be buying future contracts.

    I’m wondering if this is a way to go long oil while avoiding the contango effect.

    • Martin says:

      I do not know that fund, but if it is not involved in trading futures, like USO, then it is not affected by contango. If it, for example, buys oil companies, then its price is affected by the price of those underlying holdings and eventually recover long term. However, still be cautious as many oil companies may not survive this oil carnage. I would look for companies which pay dividends e.g. Chevron (CVX) and check their balance sheet. Those which are increasing the dividends during this mess. These are most likely the ones which will survive.

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