ETF Trends
ETF Trends

Oil traders should be aware that the holdings of ETFs like USO’s underlying portfolio includes front-month WTI future contracts, and the oil futures market is currently in a state of contango. Consequently, USO could experience a negative roll yield when rolling a maturing futures contract for next month’s 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 $53.7 per barrel Friday for February 2017 delivery, but contracts with a later delivery are trading higher, with contracts for January 2018 delivery at $57.0 per barrel.

While this phenomena is normal in the futures market, contango can have a negative effect on ETFs. ETFs that hold futures contracts sell the contracts before they mature to avoid physical delivery 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 each time. 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.

To limit the negative effects of contango, investors may consider investing in futures-backed commodity ETFs with longer-dated contracts. For instance, the PowerShares DB Oil Fund (NYSEArca: DBO) and United States 12 Month Oil Fund (NYSEArca: USL) provide exposure to WTI oil but include a different weighting methodology to limit the negative effects of contango. DBO can include contracts as far out as 13 months and dump contracts at any point to maximize gains or minimize losses associated with the implied roll yield. USL, on the other hand, ladders 12 months of contracts to better control for backwardation and contango.

For more information on the crude oil market, visit our oil category.

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