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The dramatic rise and fall of oil prices throughout the course of 2008, and into the early stages of 2009, has attracted many portfolio managers, financial advisors and individual investors to energy oriented, specifically oil, investment strategies.   While once complicated to invest directly in oil, the Exchange-traded fund (“ETF”) marketplace has once again provided a solution to this growing investor need.  There are many ETF offerings now available that allow investors to gain long or short, leveraged or unleveraged, exposure to the oil market, with some ETFs providing more direct and concentrated crude oil exposure than others.

However, as is the case with many of the new ETF strategies that have been brought to market in the last 12-15 months, the devil is in the details with each of the oil related ETF products.  Unless investors are well educated on the underlying mechanics of the instruments, they are likely to be surprised by their results.  Specifically, the tracking error between the underlying oil market and the ETFs that purport to track them in some manner has left many advisors and investors bewildered and frustrated.  To understand the cause behind this oil tracking phenomenon, we need to first understand how these products actually work and the meaning of the words “contango” and “backwardation.”

Let’s start by looking at the largest of the oil related ETF products in terms of assets; United States Oil Fund (Ticker: USO).  According to this ETF Sponsor’s website (www.unitedstatesoilfund.com) , the investment objective of this particular ETF “is for the changes in percentage terms of its units’ net asset value (“NAV”) to reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the New York Mercantile Exchange (the “NYMEX”), less USO’s expenses.”  The portfolio consists of listed crude oil futures contracts and other oil related futures, forwards and swap contracts.

Herein lies where the potential for deviation from the performance of the underlying crude oil commodity exists.  Within the USO portfolio are contracts for crude oil that roll into new contracts for crude oil on a monthly basis.  In the futures market, when prices are rising (i.e. the price of oil for future delivery is higher than the spot or current price), this would create a situation called “contango.”    When this occurs, USO stands to potentially lose value on each successive contract roll.  This seems to have been the case for USO since oil prices hit a low back in July of 2008.  According to Kevin Baker of TheStreet.com in his March 30, 2009 article entitled “Crude ETFs Keep Losing as Oil Prices Rise,” since the July 2008 low, “… even though oil prices have climbed 45% since then, the fund has lost another 4.3%.”  This phenomenon was primarily due to the aforementioned contango.

On the flip side, in the futures market, when prices are falling (i.e. the price of oil for future delivery is less than the spot, or current price), this would create a situation called “backwardation.”    In this type of environment, USO would have the potential to gain value on each successive contract roll.

Hence, everything isn’t always what it appears to be on the surface.  This adage certainly holds true with respect to many of the oil ETFs available in the marketplace today.   While these products arguably allow for a more convenient and cost effective manner in which to access the oil market, they come with their own set of pros and cons that need to be fully understood before considering an investment in such a product.  Putting aside leverage for a moment and barring expenses and other potential tracking error related factors, periods of contango can lead to underperformance, related to the underlying commodity, and periods of backwardation can lead to outperformance, related to the underlying commodity, for oil ETFs that are similar in structure and strategy to USO.  Sean Hannon provides validation to this point of view in his February 4, 2009 article on Seeking Alpha entitled, “The Hidden Leverage of Oil ETFs.”   Hannon observed the performance of spot oil prices and USO over various time periods.  His results are contained in the chart below: