Wall Street offers participants a broad array of vehicles for playing in the crude oil market. One of the most popular is the United States Oil Fund (USO). It boasts daily trading volume that dwarfs fellow commodity funds GLD and SLV, and has active options to boot.

In fact, we could hold USO up as the poster child for liquidity in the options market. The bid-ask differential in its front month options stands at a penny or two wide, and numerous strikes have open interest of over ten thousand contracts. USO options can be wielded with confidence of quick fills and little, if any, slippage.

While many trade USO, I suspect few understand its inner workings. Trading is difficult enough when you understand the dynamics driving the asset you’re trading. It’s darn near impossible when you don’t.

Let me begin by noting I think USO can be a fantastic trading vehicle to capitalize on moves in crude oil under the right conditions. However, you must understand its limitations.

The short version of today’s post is that USO is a pretty good proxy for crude oil in the short run. In the long run, however, it drastically underperforms. If you own shares of USO under the impression that it will mimic the price of oil over the long haul, prepare to be disappointed.

For the longer, more enlightening version, read on.

Contango

Every marketplace has its own unique quirks and characteristics. Moms and pops diving into the world of stock trading have to wrap their heads around dividends and shorting. Stock traders venturing into the options market have to learn the dynamics of implied volatility and the greeks. Option traders venturing into the futures market – or trading futures related products – must understand how to assess term structure and its twin related concepts known as contango and backwardation.

…and in case you didn’t know, it USO is a futures related product.

Term structure refers to the relationship between futures contracts and different expirations. In the case of crude oil, it basically reflects how the price of oil changes as you move from one expiration cycle to the next. Consider the following screenshot displaying light sweet crude oil futures (/CL) from August through December. Take note of how the price of oil futures (blue box) is rising as we move further out in time. August is trading for $52.82, September for $53.28, October for $53.73, November for $54.13, and, finally, December for $54.81.

Term structure is often displayed in graphical form to provide a short cut for analysis. The current term structure for crude oil futures can be seen below:

Notice how the term structure is upward sloping? In trader jargon, this is called contango. In other words, the front month futures are trading at a discount to back month futures. For the oil markets, this is common. Typically, back month futures do trade at higher levels than the front month.

Occasionally, the term structure inverts so that front month futures are trading at a premium to back month futures. When the curve is downward sloping like this, it’s called backwardation.

If you’re feeling a bit overwhelmed at this point, don’t worry. You don’t have to hyper-analyze the term structure of crude oil futures to dabble successfully with USO. I simply want to make sure you understand the basic concept of contango and backwardation as we’ll soon unveil the term structure of oil futures has some interesting implications with how USO behaves.

Drag

The United States Oil Fund doesn’t derive its value directly from the spot price of crude oil. It’s not like the fund owns a massive warehouse or a tanker full of barrels of oil. That would be impractical. Instead, USO uses oil futures contracts in an attempt to track crude prices for investors.  Since futures contracts expire, the fund has to continuously roll them forward over time to maintain its exposure.

Sometime between now and August expiration, USO will have to sell the August futures it currently owns and buy September futures. It’ll repeat the process before September expiration by rolling to October, and so on. If September futures were trading for the same price as August futures, there wouldn’t be a credit or debit associated with the roll. It could be done for even money, basically.

However, oil futures are usually in contango with back months being more expensive than the front month. Which means USO incurs a cost most of the time when rebalancing. Right now, for example, it would sell the August contracts at $52.82 and buy Sep at $53.28.

On a day to day basis, the roll cost’s effect is virtually imperceptible; but over time, it weighs on USO causing its performance to diverge significantly from the actual price of crude oil. Consider the sharp contrast in the price of USO and spot crude in recent years.

Despite the latest crash, at its current price of $52.82 crude oil is still 59% higher than its January 2009 low of $33.20. USO, on the other hand, is down 22% since then. That’s a massive disconnect and can be attributed to the persistent contango in oil futures.

While the downward bent of USO over time is indisputable, it doesn’t mean it fails to mimic crude oil in the short run. The best indicator to use to compare the behavior of two different securities is correlation. The scale for the correlation indicator ranges between +1.00 and -1.00. A reading of +1.00 is considered a perfect positive correlation while a reading of -1.00 is a perfect negative correlation. Anything between 0 and +1.00 suggests both securities move in the same direction. Any readings between 0 and -1.00 suggests both securities move in opposite directions.

As shown in the lower panel of the chart, the correlation between USO and the spot price of crude oil is 0.97, which is almost perfect. That means on a day to day basis USO virtually always moves in the same direction as crude oil. And yet, though it matches the direction, it doesn’t necessarily match the magnitude. Most traders, myself included, find USO does a good enough job following crude oil to be a worthwhile proxy for short-term trades.

It’s worth mentioning that if crude oil futures are in backwardation, it’ll act as a tailwind for USO. Though they are rare, periods of backwardation lead to outperformance from USO.

Yet another source of drag on USO’s performance is its expense ratio. Though its effects pale in comparison to the contango driven drag, it still has an impact. The current annual expense ratio is 0.45%, which means that every year you’re paying roughly half a percent just for the privilege of owning the fund.

Instead of rising, say 10%, over the year, USO would rise 9.55% once the expense ratio is taken into account. This is a built-in feature of all ETFs causing them to underperform their benchmarks right out of the gate.

Takeaways

Here’s the bottom line for traders: USO does a pretty good job at tracking crude oil in the short run. I’ve never had much trouble with option plays like naked puts that involve selling options with around one month to expiration. If you’re looking for a long-term bullish plays in the oil patch, however, it’s worth considering other energy ETFs unaffected by drag. I’m thinking of those tied to actual energy stocks such as XLE, XOP, or OIH.

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