USO: Take Your Money And Run

The United States Oil ETF, LP (NYSEARCA:USO) has risen by 350% since the crisis that gripped the U.S. oil sector in April 2022. Any investors lucky enough to have made money on this fund should cash out now. USO has a track record of underperforming oil prices over the long term and its recent outperformance looks unsustainable given the extreme level of backwardation in oil futures markets.

The USO ETF

According to the fund’s prospectus, the USO’s investment objective is for the daily changes, in percentage terms, of its shares’ net asset value to reflect the daily changes, in percentage terms, of the spot price of light sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in the Benchmark Oil Futures Contract. Specifically, USO seeks for the average daily percentage change in USO’s net asset value, for any period of 30 successive valuation days, to be within plus/minus 10% of the average daily percentage change in the price of the Benchmark Oil Futures Contract over the same period. USO held front month contracts until April 17, 2020, at which time following leeway in the prospectus, USO changed the exposure from holding specifically front-month contracts to holding predominantly front-month contracts, 30% next month and 15% contracts with further expiry.

Inflows into the fund surged following the oil price crash in early 2020, with assets under management rising 16x from its January 2020 lows to its April 2020 peak, when new issuance was halted. This rise in interest in the ETF, largely thanks to retail demand, has since declined by almost 80%, leaving assets under management at USD2.9bn as of today.

Not A Vehicle For Long-Term Investment

While USO tends to track the price of WTI crude oil well in the short term, it has underperformed oil prices dramatically over the long term. Since its inception in 2006, it has lost 87% of its value even though front month WTI has risen 26%. While some of this underperformance can be traced back to the regulatory changes that were imposed upon it during the April 2020 oil price crash, this only explains part of the problem.

Another issue is the fund’s expense fee, which is a hefty 0.79%. However, the main drag on performance has been the negative roll yield as the oil futures market has spent most of the time in contango. Since the front-month futures contracts are cheaper than those expiring further out in time, the futures curve is upward-sloping. This causes negative roll yields as investors lose money when selling the futures contracts that are expiring and purchasing further dated contracts at a higher price. This article by QuandaryFX goes into more detail about the problems of negative roll yield for those interested, but the key point to note is that the USO should not be held for long periods of time due to such costs. Another way to look at this cost is from an economic perspective. It costs money to store commodities and these costs must be paid by someone. By rolling over futures contracts, the USO avoids direct storage costs but only at the cost of negative roll.

Short-Term Demand Destruction About To Bite

In contrast the long-term underperformance of the USO relative to WTI, the past few months have seen the USO actually outperform significantly in part due to the oil market being in backwardation. Near-term supply fears have seen short-term oil futures trade at record premiums to longer-dated ones. While this could be interpreted as a bullish sign for the USO, my view is that it may be indicating a short-term top for oil prices as demand looks set to wane amid slowing global growth. Such periods of backwardation have often preceded declines in oil prices as the chart below shows.

As the saying goes, the cure for high oil prices is high oil prices. When oil prices rise significantly, supply rises and demand falls. I was bullish on oil prices in 2020 for this exact reason (see ‘Oil Stocks: Peak Herd Mentality’). However, after such a spectacular rise, we should expect to see marginal demand come under pressure. When we add in the impact of the self-inflicted declines oil consumption from China due to its intensifying lockdowns, and the decline in affordability across other international markets caused by the surging U.S. dollar, the near-term risks seem to outweigh the rewards.

Summary

The USO oil ETF has a long-term track record of underperforming oil prices due to its high expense fee and the nature of the oil futures market and should not be considered as a long-term investment. After gains of 350% from its April 2020 lows, the long-term declining trend looks likely to reassert itself as high oil prices begin to undermine demand.