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Snake oil: Why the $3 billion USO ETF is down this year even as crude has surged

Crude oil has bounced this year – but the USO hasn’t
Crude oil has bounced this year – but the USO hasn’t

Did you predict that oil prices would bounce in 2016? Nice! Did you attempt to cash in by buying the biggest oil ETF? That's where you went wrong.

A chart of oil prices shows that WTI crude has risen about 27 percent this year. But the USO ETF, which promises exposure to oil prices, has fallen more than 1 percent.

The structure of the futures market largely explains the disparate performances.

The commonly watched chart of crude oil is actually a chart of crude oil futures, with the most relevant futures contract on any given day being shown. For instance, on Thursday, the amount that "crude oil" is shown to move according to most data providers is really the amount that October crude oil futures rose. But a week and a half ago, September crude oil futures were tracked.

At this point it may be useful to recall that products which trade on the futures market are oddly tangible. A stock may represent a fractional amount of a company, but one cannot show up at Apple's headquarters, broker's statement in hand, and rightfully demand one's share of the company's inventory and future profits. But if you buy one oil futures contract and hold it to settlement, you truly are entitled to receive 1,000 barrels of oil in Cushing, Oklahoma, at some point in the delivery month.

At the root of the USO's trouble is the simple fact that oil set to be delivered in different months trade at different prices. For instance, midday on Thursday, October oil trades at $47.05, November at $47.75, December at $48.47, January at $49.07, and oil to be delivered in December 2017 at $52.35. This array of prices forms the futures curve, and with each month's oil trading at higher prices, the market is said to be in "contango."

In forcing a futures product into stock-market clothing, the managers of the USO have been forced to contend with this contango situation.

The way the USO endeavors to track oil is by continually holding the most relevant futures contract — the one tracking oil set to be delivered in the following month (until the contract is within two weeks of expiration). That means that on Thursday, the USO is holding the same October contract the data providers is tracking.

The problem comes when a contract's expiration is near, and the USO shifts to tracking the following month's futures. At that point, the fund's managers must sell its massive holding of the nearer-dated contract and buy about the same amount of the further-dated contract. And since further-dated contracts trade at higher prices, holders of the USO are selling low and buying high every single month. Meanwhile, the chart of oil generated by a data provider passively rolls from one contract to another, giving "oil prices" a boost even as a real-life product like the USO takes a hit.

Indeed, it is interesting to consider that while a continuous chart of crude oil futures shows a 27 percent gain this year, the now-relevant October futures has risen just 10 percent in 2016. Add in the continually rolling to higher-priced contracts and the 0.45 percent management fee, and it is clear why the USO has done so much worse than the oil chart this year. On top of this, since USO is mandated to make its roll dates public in advance, there is the potential that savvy traders are moving ahead of the fund (though the fund's manager says this has been looked into, and that there doesn't appear to have a large adverse impact).

Yet the explanation of the USO's poor performance is likely cold comfort to those who have done so badly on a trade they may have thought was a home run. The USO website, maintained by fund manager United States Commodity Funds, declares that the ETF is "designed to track the price movements of West Texas Intermediate ('WTI') light, sweet crude oil," which is not really something it has done.

"Even an investment in physical oil would be impacted by costs such as storage and insurance," John Love, CEO of United States Commodity Funds, pointed out in an email to CNBC. "Ignoring these costs is like budgeting for a house payment without considering the costs of home insurance and tax."

In a phone interview, Love added that the fund's goal is to track oil on a day-to-day basis, and he made the salient point that the continuous crude oil chart that investors are so familiar with doesn't track something that's actually investable.

Love also said that "investors have become more sophisticated about understanding the markets." But the extent to which the USO's investors actually know what they bought is an open question. With a current market value of more than $3 billion, a figure that has more than tripled in the past year, according to FactSet data, it may be a fair bet that many investors in the ETF had no idea that they would be so hurt by the structure of the futures market, which incidentally is no new development.

Looking to the future, "USO is a terrible place to be based on the contango," oil analyst Stephen Schork told CNBC on Thursday. "Being long the oil front-month and rolling into a contango market is not something you really want to be doing right now."

Instead, he advises retail investors who wish to express a bullish thesis on oil to invest in midstream master limited partnerships. There are tax-efficient structures that pass through the income generated from transporting oil. Most prominent among these is Alerian MLP, which currently has a dividend yield of 11 percent.