The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- At The FRED Report (
), we have had many questions on the oil markets over the last few weeks. There are several ways to invest in the oil space, and today we will write about the oil ETFs.
We will examine three different ETFs, and discuss the issues of Contango and Backwardation
. This article is meant to be a "jumping off point" for further examination and not a complete discussion of this issue. We realize each reader's situation is different, and it is incumbent upon the reader to determine, in conjunction with their financial adviser or brokerage firm, the correct ETF to use based on their individual circumstances.
The three ETFs we will discuss are the USO, USL, and the DBO. Of the three, the most volume and liquidity is found in the USO.
Yet, in a period of strongly rising oil prices and unrest, it may not be the best ETF to trade
. The reason for this is the phenomenon of Backwardation vs. Contango. Oil futures contracts have delivery every month. Normally, the further out months (called "back months") have slightly higher prices, which reflect cost of carry -- storage, interest rates, and the like. This is a slight Contango, which means essentially that prices of contracts further out in time have a slightly higher cost.
Right now, the oil markets are seeing "Backwardation," which means that the Delivery Month contracts, and closer in contracts are trading at a higher price than the back months
. The reason for this is simply that the market is concerned with Mid-East unrest and how that is going to affect the current delivery months, not the situation further out in time from now.
The above is important because USO uses the front month contracts to price the ETF. This can affect performance. There are two ETFs that have 12-month pricing models: DBO and USL. We show charts of all three below, and note that of late
DBO and USL have definitively broken out of their trading ranges, while USO has lagged
We believe the reason for the underperformance of the USO is that, as Mid-East tensions rise, the price of crude contracts in the back months also rises
. Those contracts that have pricing models that incorporate all 12 months of the year will therefore have an advantage -- especially because, as a contract moves into the "spot" or current position, the price rises and this can hurt USO, which has to buy these contracts at current, rather than older prices.
The 64,000 question is, "How long will this Mid-East turmoil last?" We have heard estimates of as long as two years. Should that be the case, investors should look carefully at their oil-related holdings, check with advisers, and come up with a strategy that meets their needs and follows the logic of how we have laid the various scenarios out.
Fred Meissner is founder and publisher of
. Fred is a CMT and past President of the Market Technicians Association (MTA). He recently left Merrill Lynch's Market Analysis Department and Sector Strategy Department to form The Fred Report. A detailed bio is here: