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USO Crude Oil ETF May NOT Offer You the Best Returns

Commodities / Exchange Traded Funds Oct 10, 2010 - 02:52 PM GMT

By: Jared_Levy

Commodities

Best Financial Markets Analysis ArticleFor most investors, buying and selling futures contracts may not be their cup of tea. I think futures provide not only diversity, but also a “pure play” vehicle for many commodities like crude oil, gold, silver and many others. I will tell you upfront that they do require a little bit of education and guidance.


But I’ve spent years in the options and futures market. In fact, I was a market maker. So I can give you all the guidance you need. (And you can always learn more about trading options by viewing our FREE four-part options trading course on our media page.)

The average investor, who is not yet comfortable with futures, can usually trade ETFs like USO, GLD, SLV and others as a proxy for buying the actual futures contract.

While these funds may offer an easy barrier to entry to trade commodities and other non-stock securities, there are considerations you must take into account before trading any ETF.

Check the ETF Fees
Most ETFs charge a “management” or “administrative” fee to investors who buy the shares. Fees vary depending on how “active” the management has to be and other factors. Some fees can be quite steep. The aforementioned ETFs are moderate in their fee structure.

You can check out the ETF websites for details:

GLD (and more) - https://www.spdrs.com/
SLV (and more) - http://us.ishares.com/home.htm
USO - http://www.unitedstatesoilfund.com/

Crude Oil, USO… and Something Called “Contango”
The USO is an extremely popular ETF that many investors use if they want to invest in crude oil.

There is one problem with USO. You see, the USO buys and sells front-month futures contracts only. In the futures markets, there are futures for many months going out years in time. Each and every month, the USO must sell their contracts that are expiring and buy next month’s contracts, because that is what is in the fund’s prospectus. This action is called “rolling” and the dates are listed on USO’s website.

The issue with rolling each month is something called “contango,” which is natural for crude oil. Contango is the phenomenon that futures further out in time are more expensive than futures expiring in the current month. Contango is typical in crude because it costs money to store, ship and insure oil and those costs are built into prices over time. Sometimes contango gets extremely steep, with $10+ dollars in difference within a year’s time.

So if the futures prices are more expensive from month to month, the USO fund may experience what is called a “negative roll yield.”

Here is what it looks like (this is a small example; the USO trades tens of thousands of futures contracts each month):

You have 10 contracts of crude oil in October that you can sell for $80 – you net $800.

You MUST buy $800 worth of the next month’s contracts, which are trading at $85; this means you can only afford to buy 9 contracts (balance goes into cash, which is invested in short-term Treasuries, which are essentially yielding NOTHING now).

Now let’s assume that crude rallies $10 to $95 (you own 9 contracts at $85).

You would make $90 (9 contracts x $10), where the month before you would have made $100 on the same price advance.

This does also mean that you would lose less if it dropped, but if the USO continues to go higher and higher and the contango gets more steep (which happens quite a bit) you will NOT make the returns you may expect!

While the roll doesn’t make you “lose” money necessarily, it may slow the rate at which the USO responds to movements in the long term in crude oil -- this is the key to this article.

Crude Oil Investment Alternatives
If you think crude oil is going to continue to rise, there are publicly traded companies that are involved in the entire process of getting the oil from the earth to the consumer -- from drilling and production names to transporters, to refiners, and finally to the sellers of oil and distillate products. They all have their place in the proverbial “crude food chain” and all are sensitive to changes in oil prices, some more than others

If we start first with getting the oil from the earth, you have different ways of harvesting it. The most expensive and not-as-common method is the Canadian oil sands production, which may cost up to $70-$80 per barrel just to produce. Deepwater drilling -- the process used in the BP Deepwater Horizon rig disaster in April 2010 -- costs about $50-$60 per barrel. The shallow-water drillers using jack-up-type rigs can get oil out of the ground for cheaper still.

Then there are the oil-producing countries, pulling directly from the ground on land. In the Middle East, the raw cost to produce a barrel of oil is around $20-$30, but many of these countries (other than the U.S.) subsidize social programs and offer other benefits to citizens, directly from production, so their "real" cost is likely closer to $55 per barrel.

As the price of oil drops, programs like oil sand refining and deepwater drilling become less viable, which is part of the reason companies like Suncor Energy (SU:NYSE), which develops and mines the Canadian oils, and Transocean Ltd. (RIG:NYSE), which has large exposure to deepwater rigs, may see their stock prices drop exponentially as well.

So when you select your investments, choose wisely… and always read the fine print. And if you do want to invest in USO, one method to gain back some of the potential “negative roll yield” is to sell “out of the money” covered calls against your stock!

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Don't forget to follow us on Facebook and Twitter for the latest in financial market news, investment commentary and exclusive special promotions.

Source : http://www.taipanpublishinggroup.com/tpg/smart-investing-daily/smart-investing-100610.html

By Jared Levy
http://www.taipanpublishinggroup.com/

Jared Levy is Co-Editor of Smart Investing Daily, a free e-letter dedicated to guiding investors through the world of finance in order to make smart investing decisions. His passion is teaching the public how to successfully trade and invest while keeping risk low.

Jared has spent the past 15 years of his career in the finance and options industry, working as a retail money manager, a floor specialist for Fortune 1000 companies, and most recently a senior derivatives strategist. He was one of the Philadelphia Stock Exchange's youngest-ever members to become a market maker on three major U.S. exchanges.

He has been featured in several industry publications and won an Emmy for his daily video "Trader Cast." Jared serves as a CNBC Fast Money contributor and has appeared on Bloomberg, Fox Business, CNN Radio, Wall Street Journal radio and is regularly quoted by Reuters, The Wall Street Journal and Yahoo! Finance, among other publications.

Copyright © 2010, Taipan Publishing Group


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