Positioning for an Oil ETF Rebound? Watch For Contango. | ETF Trends

As crude oil prices dip to fresh lows, contrarian traders are becoming increasingly antsy for a rebound. Traders may try to tap into an oil-related exchange traded fund to capitalize on a potential recovery, but one should first look under the hood and understand how the futures market can affect an ETF.

For instance, many would likely turn to the U.S. Oil Fund (NYSEArca: USO), which tracks West Texas Intermediate crude oil futures, to play a potential turn in the energy market. USO is the largest and most popular oil-related ETF option on the market, with $1.2 billion in assets and $387 million changing hands daily, according to Attain Capital.

However, oil traders should be aware that USO tracks front-month WTI future contracts and the underlying oil market is currently in a state of contango. Consequently, USO could experience a negative roll yield when rolling a maturing futures contract.

Contango occurs when the price on a futures contract is higher than the expected future spot price, which creates the upward sloping curve on future commodity prices over time. Essentially, the phenomenon reflects a current spot price that is lower than the futures price. For instance, WTI futures were trading around $48.2 per barrel Tuesday for the February 2015 delivery, but contracts with a later delivery are trading higher, with contracts for December 2015 delivery at $55.1 per barrel. [WisdomTree: Long Commodities, Short Contango via Commodity Currencies]

Commodity prices are typically higher in the future because people would rather pay a premium to have the commodity on a later date instead of paying the costs for storage and the carry costs for buying the commodity right now.

While this phenomena is a normal occurrence in the futures market, contango can have a negative effect on ETFs. Specifically, ETFs that hold futures contracts sell the contracts before they mature and purchase a later-dated contract. In a contangoed market, the ETF loses money each time it rolls contracts to a costlier later-dated contract – the fund would technically sell low and buy high. Consequently, long-term investors may notice underperformance to the oil market since the ETF holds front-month contracts and would see a slight cost when rolling each front-month contract. [Backwardation & Contango]

“This is why $USO has drastically underperformed the “spot price” of Oil over the past five years, with $USO having lost -39% while the spot price of Oil went UP 48%,” according to Attain Capital. “It is like an option or insurance premium – a declining asset with all else held equal.”