The Crude Oil Contango

The Crude Oil Contango: How to Profit From Rising Oil Prices

by Matt Weinschenk, Senior Analyst, The White Cap Report
Wednesday, January 28, 2009: Issue # 923

Editor’s Note: Last Saturday, we sent out a special broadcast on an oil situation called “Contango.” We’ve received a lot of response from that broadcast. Many investors have jumped on the crude oil contango bandwagon in recent days. But not all of them are doing it correctly. Take a look at the follow up below, and you’ll see why.

You might think you’re properly invested in oil, but you could be wrong.

Despite reaching lows since 2004, the long-term outlook for oil is still up. Maybe not $147 a barrel like the old days (i.e. six months ago), but because of supply, demand, turmoil in the Middle East, and the fact that we will eventually resume worldwide economic growth, oil prices have only one way to go.

If you think you’ve positioned yourself according, or if you’re thinking about a new investment in crude oil… tread carefully. Here’s why:

I uncovered a situation last week call contango. It’s a feature of futures markets where you can buy crude oil cheap right now and lock in a contract to sell it in the future for a higher price. Normally, the difference between those prices is so close to the cost of storing the oil that it’s not a profitable trade.

But right now, we’re in a state of super-contango. Prices are way out of whack. And commodity investors are storing crude oil everywhere they can to earn the excess profits.

Contango is big news now. But some of the “traditional” oil investments that are being tossed around aren’t what they seem to be. In fact, if you skipped some very fine print, you could have set yourself up for a huge disappointment.

So let’s clear that up… and pad our pockets with a little extra cash in the process.

The Crude Oil Contango – How To Profit

When we broke the news on the crude oil contango, we suggested looking at some oil storage providers, explorers and drillers. And that hasn’t changed. Looking around, there are a number of “oil investments” that look promising.

One would think the quickest way to invest in rising oil prices would be to simply buy shares of an oil-based ETF, like United States Oil (NYSE: USO). These oil ETFs are very popular – USO trades over 34 million shares per day.

But not so fast.

These funds don’t buy and sell crude oil for profit. They trade futures contracts on oil. And while there are a few ways to do that – some good, some bad – they may not be the best way to take advantage of contango. Let me explain.

USO buys a contract for crude oil for the very next month. Before it expires, they sell it off and buy one for the next month. In a contango situation the returns will indisputably be lower. (Conversely, during the opposite of contango, “backwardation,” the fund returns will be higher).

USO makes no secret of this. They print it in their risk disclosures that contango is not good for their fund.

And they are not alone. The iPath GSCI Crude Oil ETN (NYSE: OIL) and the Powershares DB Crude Oil ETN (NYSE: OLO) use the same methodologies. (Though OLO actively manages its roll forward strategy to reduce losses.)

But don’t give up on investing in oil.

The Crude Oil Contango – Using Custom Designed ETFs

In fact, the same manager that runs the USO fund runs another exchange traded security that’s custom designed to benefit from situations like the crude oil contango. It’s called the United States 12 Month Oil Fund (NYSE: USL). It uses a 12-month average of futures prices that will lessen the losses caused by a contango market.

Here’s the interesting thing. Oil markets usually exhibit a small amount of contango, it’s a natural result of price fluctuations. But its opposite, backwardation, is the rarity. So even if we were in a normal oil situation, wouldn’t the 12 Month Fund be better?

In fact, wouldn’t it make sense all the time? It would seem to be so.

USL vs. USO

Obviously, “new world” oil prices have been down… but you’d have fared significantly better investing in USL. Reading the fine print on an ETF isn’t the most entertaining way to spend your day, but it’s certainly worth a near 15% difference in performance.

If we were to enter a backwardation period, USO would then outperform. But since backwardation is so rare… you can expect USL will outperform consistently over the short and long term.

Ahead of the tape,

Matt Weinschenk

Today’s Investment U Crib Sheet

In honor of the Chinese New Year, we have a number of ways you can profit from the “Chinese Dragon.” In fact, Lou Basenese gave us 11 reasons we should be looking at China now. To find out more, see “Investing in China: 11 Reasons Why and 5 Ways to Buy.”

Investment U has been updating our homepage, and following in the spirit of “New,” here are the last three “Stock of the Day’s.”