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Futures vs. ETFs Performance Differences

Here’s an interesting, but somewhat complex question about oil trading I had come in by email. Well, at least the answer is complex.

Hi John,

While checking a performance comparison for the last 200 days between USO and the WTI Continuous Contract, I noticed that they had very similar performance up to the end of 2008, and from the start of 2009 they began diverging, with the ETF significantly underperforming the futures contract. What happened around new year’s time that suddenly caused this divergence? And what other ETF can I choose that better mimics the price action of WTI if I would rather avoid trading the futures contract?

Thank you

Rod

I’m not an oil trader or analyst (though back in the day I would cover the energy markets on a fill-in basis from time to time), so the really market-specific stuff is beyond my knowledge. I’ll do my best, though, to explain what I suspect is contributing to the difference in performance between the USO and the front month futures, which is basically what the continuous contract tracks.

US Oil Fund (USO) ETF
First of all, we need to look at what makes up the holdings of the USO. According to the fund website, the objective of the fund is:

… for the changes in percentage terms of its units’ net asset value (“NAV”) to reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the New York Mercantile Exchange (the “NYMEX”), less USO’s expenses.

At this writing the fund is indicated to be long about 45,000 contracts in the July futures, a position with a value of about $2.79 billion as of the May 20 closing price. The fund also shows nearly as much in cash ($2.76 billion). In and of itself, that sort of positioning would be a very good reason why USO is under-performing the front month futures contract. The ETF isn’t fully exposed to it so they cannot possibly match the gains.

I don’t know how those relative weightings have changed over time, though, so I cannot go beyond the current observation to specifically say that’s the entire reason. There may be other factors involved as well (see below). The big cash position definitely stands out, though.

Other Oil ETFs
There are a handful of other oil-focused ETFs out there. Here’s a list:

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

Some of the ETFs take an approach similar to USO in which they focus their holdings on front month futures to try to track nearby prices. Others, though, such as USL, actually use a spread of futures contracts across an array of months. That creates an interesting dynamic when it comes to comparing performance vs. the front month futures.

Contango and Backwardation
In normal circumstances prices of futures further into the future are priced cheaper than those in the front month. That’s a situation known as backwardation. The price of oil in the ground is less than the price of one in a barrel. Sometimes, though, things flip around into contango, which is when foward prices are higher than current ones.  That can come when near-term demand drops or there’s a glut of supply.

Now, if things hold in either contango or backwardation one would generally not expect to see much difference between the performance of front month oil and that of an ETF which includes holdings of several different month futures. When the situation flips, though, one of the two is going to outperform, potentially by a large margin. For example, if the market goes from backwardation to contango (means forward contracts go from priced less than front month to being price higher) an ETF holding forward months is going to outperform the front month futures (and vice versa in a contango to backwardation switch).

So the bottom line in all this is that you should make sure you know what the ETF you’re trading or investing in is holding so you can know what to expect.