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March 27, 2015

Contango Kills Oil ETFs

By Tim Maverick, Commodities Correspondent, Wall Street Daily 
Oil investors should open their eyes to the valuable lesson those in the natural gas industry learned the hard way…
There is no direct correlation between the number of drilling rigs and the amount of oil produced.  
In the Marcellus Shale, the number of rigs peaked in 2012 at 144. That number dropped to 98 over the next three years, yet production more than doubled.
The same principle will likely hold true for oil.  
You see, the number of drilling rigs in use is falling, but output is surging thanks to advances in horizontal drilling technology. Production at the five big shale oil formations in March hit a record level, despite the number of rigs dropping to the lowest level since 2013.
This is a key factor behind many forecasters saying that oil prices may have further to decline or, at the least, not rise.
At the recent Investment U Conference, our own Karim Rahemtulla said that oil would remain under $60 per barrel for the next six months.
Yet investors are continuing to buy exchange-traded funds (ETFs) that hold oil futures contracts as if oil were going to trade at $100 per barrel tomorrow. This is bound to be a big mistake.
Swept up in the Mob Mentality
It has truly been a buying frenzy. The five biggest oil ETFs in the world have seen their assets more than quadruple to $5.4 billion since July!
In fact, today over 30% of the most active U.S. oil futures contract is now controlled by the holders of ETFs. These ETFs now hold the equivalent of 175 million to 180 million barrels of West Texas Intermediate oil.
According to the Financial Times, this year investors have put more than $2 billion into the largest oil ETF, the United States Oil Fund (USO), raising its assets to $3.1 billion.
Less than 20% of the shares are held short, so the vast majority of the holders are betting they can make boatloads of money when oil rebounds.
But the odds of that happening are slim.
Contango Is a Killer
Take a look at the last time oil bottomed at the end of the financial crisis in 2009. Oil prices more than doubled, yet USO only rose by about 50%.
Why​? It was the portfolio killer, contango.
This is a condition in the futures markets when prices are higher on longer-dated contracts than the near-term contract. And it’s what’s happening now with oil.
For oil ETFs, this allows the ETF to afford to buy fewer barrels of oil each time it must sell a current contact and buy a new oil contract. This is known as a roll yield loss.
Contango also makes these ETFs more of a vehicle for short-term trades, rather than a good way for small investors to profit long term from a rise in oil prices.
And the people rushing into these ETFs may have another surprise waiting for them… lower oil prices still to come.
Wall Street Daily’s Chief Resource Analyst recently covered the major reasons oil prices may fall.
Speculators, or “dumb money,” could also contribute to the crash. These investors are still hugely long oil to the tune of nearly 300,000 contracts. These same speculators were also wildly bullish when oil peaked in June 2014. These type of speculators usually end up dumping their positions in a panic at a big loss, driving down prices in a hurry
In contrast, the commercial hedgers, or “smart money,” are still short 300,000 contracts.
Bottom line: Don’t expect to make a killing any time soon with oil ETFs. The odds are stacked against you.
Courtesy Wall Street Daily (EconMatters article archive Here)   

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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