Why commodity ETFs are a bad investment

October 21, 2010

Commodities

Commodity ETFs are financial instruments that are supposed to enable small retail investors to invest in commodities such as oil and gold. Now normally, commodities are bad assets to invest in. They do not have any cash flow, incur storage costs, and will not grow. At first sight, then, commodity ETFs appear to be miraculous instruments. They are marketed as perfect proxies for physical commodities, but with no storage costs.

Futures-based ETFs, which includes all the oil ETFs such as USO, OIL, and DBO, all employ the strategy of buying (say) the 6 month futures for oil, and then selling the same futures 3 months later (when it is a 3 month futures), and reinvesting the money in a new 6 month futures. In this way, the oil is always “coming”, but never actually arrives, hence there is no need to pay for storage.

However, this buying of long-dated futures and selling of short dated futures by USO has an effect in the oil futures market. Normally, long-dated oil futures are priced slightly higher than short-dated futures, a phenomenon known as contango. Contango occurs because it costs money to store oil for delivery later. The contango curve is usually quite shallow, amounting to perhaps 2-3% over 3 months. Since the entry of USO into the oil futures market, its activity has caused contango to sharply increase, to as much as 10% over 3 months. Contango is now so severe that it has spawned a brand new hedge fund trading strategy known as the contango trade. Basically, traders in large firms such as Goldman Sachs buy oil on the spot market, store the oil in oil tankers for 6 months, at the same time selling 6 month oil futures at a higher price, reaping the difference. Because this is a perfectly hedged trade (the oil is sitting in tankers, so no matter what the oil price is in 6 months, the oil can be delivered), traders are able to lever up the trade with borrowed money at wholesale rates of 1-2%, making huge profits even after deducting oil storage costs. The loser in this trade is the USO ETF, which loses money each time it sells its short-dated 3 month futures to buy long-dated 6 month futures.

How has the USO ETF performed with respect to crude oil prices? On Aug 4 2009, the spot oil price is $71.78 per barrel, and on Aug 4 2010, spot oil is $82.39, a rise of approximately 15%. USO, on the other hand, has gone from $38.20 on Aug 4 2009 to $36.48 on Aug 4 2010, a LOSS of 4.5%. This is a tracking error of nearly 20%, due largely to its constant contango losses in the futures market. It is important to note that long-term investors are especially penalized, as the longer you hold USO, the larger are the contango losses.

In short, financial engineering cannot produce a commodity ETF that is free of storage costs, just like it cannot turn subprime mortgages into true triple A securities. USO has merely outsourced its storage requirements to traders at Goldman Sachs and other trading outfits, and has done so at an exorbitant price far above the true costs of storage. The real losers are the small investors who invest in these commodity ETFs believing that they can escape storage costs. Commodity investments will always carry a negative yield due to storage costs, and are unsuitable long-term investments.

More on this topic (What's this?)
Twitter Digest: 2012-10-24
Read more on Commodity ETFs, Oil at Wikinvest

{ 1 comment… read it below or add one }

http://Aliyahfernand.Wordpress.com/ March 21, 2013 at 7:44 pm

I’m not sure where you’re getting your information, but good topic.
I needs to spend some time finding out more or figuring out more.
Thanks for magnificent info I was searching for this information for my mission.

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