MW: Crude awakening Oil's rally leaves many investors
By Moming Zhou, MarketWatch
NEW YORK (MarketWatch) -- Most of us can't stockpile barrels of crude oil in the backyard, nor would we want to. Yet with oil prices soaring, many investors are eager to fill their portfolios with this precious fuel.
Accordingly, a specialized group of exchange-traded funds taps into oil rallies. But investors should be aware that while these funds have been posting solid gains, they are complex, risky instruments which don't fully capture oil-price moves.
At best, these oil-linked ETFs, which trade on an exchange like stocks, are an indirect pipeline to oil. That's because unlike some gold and precious metals funds, oil ETFs don't hold the physical commodity. Instead, they trade oil futures contracts, and that can impact investment returns in ways unsophisticated buyers never expected.
"There is no way to directly invest in oil," said Bradley Kay, an ETF analyst at Morningstar. "Indirect investments such as oil company stocks, futures, and oil ETFs tend to have a lot of complicated moving parts."
Primed for a pump
Oil prices have soared more than 80% this year, but investors in oil ETFs have realized a much smaller gain due to the way the funds are structured and patterns in oil markets that few individual investors completely understand.
United States Oil Fund (USO 40.89, -0.02, -0.05%) , the biggest oil ETF, is up 25% so far this year, while iPath S&P GSCI Crude Oil Total Return Index (OIL 27.50, -0.39, -1.42%) , an exchange-traded note, gained 18%.
Oil ETFs buy futures contracts, which promise the delivery of oil on a certain date of each month. Problems arise when contract prices are higher for delivery further out than near-term. For example, if a contract to deliver oil in February is more expensive then the contract for January delivery, the market is said to be in "contango."
U.S. Oil Fund and the Barclays iPath fund are both vulnerable to this condition because they buy contracts nearest to delivery, sell each month and buy the next month's contracts. Nowadays, that means the funds are selling low and buying high.
Two rival ETFs, PowerShares DB Oil Fund (DBO 27.80, -0.24, -0.86%) , and the United States 12 Month Oil Fund (USL 41.56, -0.33, -0.79%) , employ different strategies to alleviate the impact of contango and are doing much better. The PowerShares ETF is up 46% so far this year, while United States 12 Month Oil has gained 40%.
Difficulty understanding such arcane market patterns and structures seems not to have deterred investors, who, encouraged by rising oil prices, are captivated by commodities. But contango's impact on fund returns and the scarcity of better choices in oil-related investments is a stark reminder that investing in commodities isn't easy.
"If you want to invest in oil ETFs, it's crucial to understand the market patterns such as contango and how they affect the returns," Kay said. "It's better for ordinary investors to stay clear of any investments that they don't understand."
Both U.S. Oil Fund and the Barclays ETN use a straightforward futures structure. These funds hold the nearest-month contract and roll over to the next month a few weeks before the current one expires.
This strategy, while easier to manage, subjects the funds to the brunt of contango.
Futures have remained in contango since late 2008, once seeing a record gap of nearly $8.50 a barrel between an expiring contract and the following month contract. That's a big reason why U.S. Oil Fund and the Barclays offering have seen such relatively poor returns this year.
