There has been an increase in interest in the oil market with prices being at multiyear lows. To try and profit off these low prices, retail investors in particular have been buying into oil ETF’s under the assumption that they are buying oil at the current price they see on the day. An ETF is a type of tradable security that is made up of a collection of securities that often tracks an underlying index or in this case oil. If an ETF tracks an index made of underlying stocks, then its price movement can reflect the movement of the underlying stocks quite closely. However in the case of oil ETF’s, they are made up of a number of oil futures contracts, and this means they do not track the underlying price very closely. A futures contract is an agreement to buy or sell an amount of an asset at a specified future date for a certain price.
The reason oil ETF’s do a bad job at tracking the oil price is that when a futures contract is coming close to the date of that contract and is therefore about to expire, it needs to be ‘rolled’ into another futures contract whose date is further out. This is called a longer dated futures contract. When the price of the longer dated futures contract is higher than the price of the near dated futures contract it costs money to roll the contract as you are paying more for the longer-term contract than you are selling the near-term contract for. This erodes value for a holder of the ETF. The reason that you saw the price of oil go negative a few weeks ago was due to ETF’s being forced to roll the May contract into longer dated contracts when nobody wanted the May contract as there was very limited storage capacity available to take delivery of the oil – i.e. the holder of the May contract at expiration would need to take physical delivery of the oil. The price going negative meant the holders of the May contract were paying people to take delivery of oil that they did not want or have storage space for.
Longer dated oil contracts continue to be more expensive than shorter dated ones. This means that to ‘roll’ a futures contract in this environment is very expensive but oil ETF’s are forced to do so. If the ETF decided not to roll the contract, they have to take delivery of the oil which is impractical. The world's largest oil ETF, $USO, has had to contend with these market dynamics and the costs of rolling these contracts.
As can be seen below, since the inception of the USO ETF in 2006, the oil price is now worth 56 versus 3.5 for USO – i.e. oil is down 44% however USO (taking the costs into account) is down 96.5%.
Prices standardised to 100 (click to enlarge):
