Oil and Gas ETFs: Dirty Truth - TheStreet

Oil and Gas ETFs: Dirty Truth

If you're going to use these messy products, says Dan Dicker, use them for daytrading, and try to stay clean.
Publish date:

I've been screaming at the top of my lungs, telling people not to trade oil and gas ETFs like U.S. Oil (USO) - Get Report and U.S. Natural Gas (UNG) - Get Report. They're perfectly horrible investment vehicles.

But nobody will listen to me. They just love those new ETFs.

So instead of screaming in this column, I'll instead play Mother Hen for a moment. OK, kids, if you're going to play in the mud, here's what you need to wear to stay relatively clean.

Everyone these days it seems wants crude oil exposure as part of his or her portfolio or they just want to be able to daytrade the price of the crude barrel.

Avoid Oil ETFs, Buy Stocks

var config = new Array(); config<BRACKET>"videoId"</BRACKET> = 30284198001; config<BRACKET>"playerTag"</BRACKET> = "TSCM Embedded Video Player"; config<BRACKET>"autoStart"</BRACKET> = false; config<BRACKET>"preloadBackColor"</BRACKET> = "#FFFFFF"; config<BRACKET>"useOverlayMenu"</BRACKET> = "false"; config<BRACKET>"width"</BRACKET> = 265; config<BRACKET>"height"</BRACKET> = 255; config<BRACKET>"playerId"</BRACKET> = 1243645856; createExperience(config, 8);

This is exactly the tendency -- actually more like a trading craze -- that I've termed "the endless bid." Investors and traders have made crude oil part of their daily diet of speculation where it barely existed even three years ago.

And more and more they are getting their fix for crude oil through exchange-traded funds.

And why not? They look like stocks, they sort of act like stocks and therefore are a lot more comfortable for people who have a lifetime of experience with stocks.

But they're not stocks -- not at all.

I could explain how the use of crude oil ETFs are a dastardly contributor to price volatility, but no one wants to listen.

I could explain how ETFs have clearly inflated the average price of the crude barrel and the cost of a gallon of gas to the consumer, but no one wants to hear it.

I could also try to explain how ETFs contribute to the flow of capital from Americans into the coffers and sovereign wealth funds of oil-producing nations that aren't entirely sympathetic to our way of life, but it would fall on deaf ears.

Instead, since the trading volume of these commodity ETFs continues to increase, let me tell you why you're not getting the investment you think you're getting and at least how to keep yourself as safe as possible while you're trading them.

When you buy or sell USO or UNG, you generate orders electronically in the futures markets for oil and natural gas.

While those orders move prices in the futures market, they also get reflected back to the price of the ETF. The idea is for each market to move perfectly in lockstep so you can use the ETF as a proxy for the futures market.

But it doesn't work out that way. Futures aren't stocks.

For one thing, they don't have a set number of "shares." With a stock, there's a known "float" that investors must "fight" each other to possess. That's how value and price are discovered. But futures theoretically have no limit to the number of contracts that can be written. Price and value are intended to be discovered in another way, and ETF trading can distort those mechanisms.

Futures also have a curve of monthly delivery contracts, and the reported price you see is the price for the first month only, the "spot month," which has a lifespan of at most 30 days. After that time, all contracts in the ETF that haven't been liquidated need to be "rolled forward" and try to reflect the next month out on the curve -- the one now becoming "spot."

That doesn't always work out so well. If the next month on the curve is higher priced, there will be a necessary discounting for ETF holders. This contango condition, which has been a regular feature of the crude market for the last year, has discounted the value of oil ETF-holders consistently for the longer they've held on.

Check these charts of USO vs. crude:

I'm using a crude chart made up only of spot month prices. But look what happened as crude went on its steep decline from $147 to $30 last year.

If you decided to buy crude during this drop last fall using USO at a spot price of around $70 a barrel, you'd have paid around $60 a share. But as crude oil rallied to well over $70 a barrel in the last month, USO never got close to $60 a share -- it didn't even touch $40. That's the discounting power of the contango.

Surprisingly, the ETF can be just as punishing for the short-player, too. The longer you hold it, the less bang you get for your trading buck. I could show similar examples where you could have held short through a rally and not recouped your losses even though the price of the barrel returned to where you started.

It's just a lousy investment.

But if you're going to use it, and I know that you are, know this: The shorter your time horizon is, the less you are going to give away. If you must use the ETFs, use them as daytrading devices only, and even then, it's better to have them for even less than a day.

My advice continues to be: If you want to trade futures,

trade futures

. Get a specialized futures account and trade the E-minis; they have terrific platforms to trade futures where you can get as comfortable as with your stock-trading platforms.

And if you're looking for a long-term oil investment that acts like a stock,

trade stocks

. There are plenty of stocks whose correlation with oil's price is so strong, you can use them almost totally as proxies for long-term oil price investment.

But I know you're going to go out there and play in the mud. I can't seem to stop you. Just try to keep as clean as you can.

At the time of publication, Dicker had no positions in the stocks mentioned, but positions can change at any time.

Dan Dicker has been a floor trader at the New York Mercantile Exchange with more than 20 years' experience. He is a licensed commodities trade adviser. Dan's recognized energy market expertise includes active trading in crude oil, natural gas, unleaded gasoline and heating oil futures contracts; fundamental analysis including supply and demand statistics (DOE, EIA), CFTC trade reportage, volume and open interest; technical analysis including trend analysis, stochastics, Bollinger Bands, Elliot Wave theory, bar and tick charting and Japanese candlesticks; and trading expertise in outright, intermarket and intramarket spreads and cracks.

Dan also designed and supervised the introduction of the new Nymex PJM electricity futures contract, launched in April 2003, which cleared more than 600,000 contracts last year alone. Its launch has been the basis of Nymex's resurgence in the clearing of power market contracts over the last three years.

Dan Dicker has appeared as an energy analyst since 2002 with all the major financial news networks. He has lent his expertise in hundreds of live radio and television broadcasts as an analyst of the oil markets on CNBC, Bloomberg US and UK and CNNfn. Dan is the author of many energy articles published in Nymex and other trade journals.

Dan obtained a bachelor of arts degree from the State University of New York at Stony Brook in 1982.