Schork Oil Outlook: The Problem with Energy ETFs

Interesting article on Bloomberg yesterday (Wednesday) regarding the drubbing investors have taken in long-only energy ETFs —Wall Street’s tut-tutting to the contrary notwithstanding.

It seems that buying into the energy rally vis-à-vis the USO (crude oil) and UNG (natural gas) has added significant ballast to your portfolio despite a significant rise in both commodities.

For instance, following the implosion in the energy bubble in July 2008, spot NYMEX WTI bottomed at $32.40 on December 19th, 2008. Since then WTI has more than doubled (+106%) as of last night’s close. Unfortunately for the saps… um… shareholders of the USO, the fund is up a meager 1.4%! It is even worse for natural gas bulls. Despite a steep selloff since the winter, the NYMEX Henry Hub futures contract is still up by 48% since it bottomed back in September. The UNG is down (!) by 30% since then.

Compare the performance of these energy funds to the GLD (the long-only gold fund). After bottoming in November 2008 COMEX gold futures have jumped by 61%. That is only slightly better than the 59% return on shares in the GLD.

So why has gold turned out to be such a good investment while oil and gas funds have been so lousy?

Unlike gold, consumption commodity markets such as energies, softs and industrial materials are defined by backwardation, i.e. an inherent bias to the spot market as a result of a convenience yield or a premium to provide the underlying commodity to the market as demand dictates.

  • NatGas, Crude, RBOB Futures

Think of it this way: every week when I pull into a filling station I expect that station (and the two other stations competing for my business across the street) to have gasoline on request. On the other hand, unless it is our anniversary (and not even necessarily then), my wife is not expecting me to hand her gold every week.

Thus, when demand for gasoline, copper, corn… etc. is strong, that demand gets priced into the spot market as end-users are compelled to lock-in supplies. However, when demand is weak (relative to supply) end-users are more comfortable with letting their requirements float and only going onto the spot market as needed. This lack of compulsion to own the physical in the here-and now invariable leads to weakness in the front-end of the futures curve, hence the contango (near-term contracts at a discount to deferred contracts).

The oil and natural gas markets have been defined by contango since 2008. Therefore, every time the USO and UNG have to roll their length in the futures they have to sell the cheaper spot contract and buy the more expensive second-month contract. In other words, because of the negative roll yield the fund shareholder is effectively locking in a “loss” each month.

Schork Reportbottom line: Beware of Wall Street touts selling bullish products in a contango; because if demand were greater than supply (our prosaic definition of a bull market) then that market would be defined by backwardation.


Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.