Saturday, August 13, 2011

How To Trade Oil - USO

I have already posted why I believe trading oil is more likley to lead to profitable trades than alternatives like currencies, stocks, markets, metals etc.

See USO - Saudi's Got My Back where you may detect that I am not all that excited about using USO as the means to trade oil.

I have two charts with which I can illustrate two of the short comings of USO. This first chart is a comparison of the performance of USO against some popular oil industry ETFs that contain stocks rather than oil futures contracts.

You can see that the ETFs IEZ, OIH, XLE are more highly geared to the oil price than USO. There are lots of effects at work to create this, but one is that each company has a base cost to product oil lets say 50 dollars a barrel. If the oil price moves from 80 to 85, the value of oil after costs has gone from 30 to 35, an increase of  16%, but the price of oil itself has only increased 6.25 %. This is a massive over simplification, not all of the 16% is within the producer, it will be spread around the supply chain, but it illustrates why oil companies provide a leveraged play on the oil price.

The next chart shows the long term underperformance of USO against the same selection of oil industry ETFs. As a long term hold USO is a disaster. If you had bought any of the ETFs One year ago, you are still holding onto 20% profit, with USO you are down about 5%.

The reason for this is the way that USO is structured. It uses futures contracts to track the price of oil. The fund never takes delivery of physical oil but instead rolls the contracts. Basically this means that as the contract approaches expiry, the contract is sold and the funds are reinvested in oil further out in the future. This is an expensive strategy, there are transaction costs and time decay elements which eat away at the fund over time leading to a guaranteed under performance.

So far USO has been a disappointing trade, my entry points have well chosen given the weeks price action but the returns are minimal.

As the charts illustrating the long term underperformance of USO show, it is not a position to hold for any length of time. I will be closing this position soon out of boredom with the lack of action.

There is one glimmer of hope for this trade, if the markets blow up on Monday I will double down by selling USO and reinvesting the funds in DIG a far more exciting play on oil.

Three months price action DIG vs USO (45% top to bottom vs 22% top to bottom)

For information on all the ETFs Mentioned, link below -

IEZ, OIH, XLE, USO, DIG Detailed Summary - Yahoo Finance

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