Tuesday, June 16, 2009

Your Guide to Trading Oil ETFs

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06/04/09 - 09:37 AM EDT

USO , OIL , UOY , OLO , USL , DBO , DXO , UCO , SZO , DOY , DTO , SCO , DB
Don Dion

Two days before Christmas, the West Texas Intermediate crude oil (benchmark for New York Mercantile Exchange futures contracts) spot price bottomed at $30 per barrel and traded below the price of international crude oils -- whereas historically it had traded slightly above -- due to a lack of inventory at the Cushing, Okla., delivery point.

The pricing anomaly exacerbated the problem of contango -- when the next month's futures contract costs more than the current month. The episode highlighted in extreme form some of the differences among various ETFs, ETNs and ETPs that track the price of crude oil.

As of yet, there is no ETF that models the gold and silver ETFs by accumulating and storing oil. Instead, a mix of products offers unique ways of investing in the world's most important fuel through futures contracts.

The major differences, aside from the ETF and ETN distinction (with their attendant tax and credit-risk drawbacks), are timing and how the underlying index deals with contango and its opposite -- backwardization. U.S. Oil(USO Quote), for instance, rolls contracts each month, while PowerShares DB Oil(DBO Quote) follows the Deutsche Bank(DB Quote)Optimum Yield Index that opts for the best contract to minimize contango or maximize backwardization.

There's also another product offered by MacroShares: $100 Oil Up(UOY Quote) and $100 Oil Down(DOY Quote). MacroShares are sold in pairs -- for every long oil share, there is a short oil share. All the money is placed into Treasuries and cash.

When the price of oil rises, MacroShares shifts money into the up shares, and when the price drops, money shifts to the down shares. The shares have expiration dates but may also terminate early if certain conditions are met. A previous iteration terminated last year, and these shares are set to terminate in June. Investors may have the opportunity to invest in another set of these shares, but judging by the volume, the concept is not popular with investors.

Among the remaining long funds are USO, U.S. 12 Month Oil(USL Quote), iPath S&P GSCI Crude Oil Total Return Index ETN(OIL Quote), PowerShares DB Crude Oil Long ETN(OL Quote), PowerShares DB Crude Oil(DBO Quote).

In late 2008 and early 2009, there was a serious issue of contango and the unprotected indices suffered: USO and OIL had returns of 9.5% and 2.6% this year, respectively, compared with 48.3% for spot WTI crude. USL, designed to mitigate the problem of contango, performed as advertised with a 23.1%. Finally, DBO and OLO returned 29.0% and 25.9%, respectively.

On the basis of performance, fees and volume, DBO and OLO appear to be the best bets. OLO has consistently underperformed DBO, but small investors who do their own taxes may find that the time saved on their taxes outweighs the underperformance and credit risk.

OLO's poorer showing is the result of credit risk being priced into the security. Therefore, expect a widening of the gap if credit markets deteriorate (the gap was widest in September 2008), whereas a functioning credit market could give OLO a boost if the gap closes. If contango evaporates or even turns into backwardization, USO should be considered, as it has lower fees and higher volume. Finally, although OIL underperformed, it has significantly more assets and trading volume than DBO.

For leveraged long funds, the choice is between the monthly PowerShares DB Crude Oil Double Long ETN(DXO Quote) and the daily ProShares Ultra DJ-UBS Crude Oil Index(UCO Quote) ETF. Functionally, there is no choice. DXO is up 65.9% in 2009 compared with an 11.7% loss for UCO. Although DXO has four times the volume, UCO's dollar volume is not far behind DXO, although DXO has more assets under management.

On the short side, there is effectively one option with the expiration of the MacroShares pair -- PowerShares DB Crude Oil Short ETN(SZO Quote). It is down 19.4% this year. The far more popular leveraged short funds offer the same two choices as the leveraged long funds -- the PowerShares DB Crude Oil Double Short ETN(DTO Quote) and the ProShares UltraShort DJ-UBS Crude Oil Index(SCO Quote).

Both performed badly as oil declined this year, but DTO has more assets, and both have roughly the same dollar volume. Also note that the short and leveraged PowerShares ETNs do not use the Optimum Yield Index but instead use a standard roll index.

As investors and traders sort out the direction of the market, commodity prices are likely to remain volatile and the leveraged ETFs even more so. Thus far the PowerShares funds, whether ETF or ETN, long or short, leveraged or not, appear to be the best performers. Their advantage is more on the upside, although thanks to the Optimum Yield Index, the short funds have performed similarly to ProShares on the downside. Until market conditions change, these are the best bet.

Oil ETFs
Fund YTD Return (%) Mgmt. Fee(%) Avg. Volume (000s)
WTI Crude 48.3 - -
Long
USO 9.5 0.45 18,567
OIL 2.6 0.75 2,252
UOY 14.6 0.95 17
OLO 25.9 0.75 30
USL 23.1 0.6 229
DBO 29 0.5 304
Double Long
DXO 65.9 0.75 28,600
UCO -11.7 0.95 7,355
Short
SZO -19.4 0.75 19
DOY -9.8 0.95 2
Double Short
DTO -44 0.75 222
SCO -40.1 0.95 1,041
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