Wednesday, June 3, 2009

How to Play Oil Contango

There is a straight way to play oil contango: buy physical oil and oil futures for the equal amount of it several months ahead. Store oil in Cushing, OK or in supertanker somewhere offshore, paying about a dollar per barrel per month and deliver it when future contracts expire. This is for serious oil speculator, who has big capital.

Is there anything individual investor can do? And filling up your swimming pool with crude is not what I have in mind. Yes, there is a possibility to speculate on contango.

Let's take a look at U.S. OIL FUND ETF (USO). As everybody knows, oil price, which usually means next month future contracts for West Texas Intermediate oil (WTE), almost doubled since beginning of the year. USO, which represents next month WTE futures, is up whopping 9.5%. WTF? There is a small problem with USO design: this ETF buys next month future contracts, and in the end of month rolls them over to the following month. Of course, in case of contango, it buys less contracts for the following month, because they are more expensive. Repeated every month, this procedure kills USO in case of contango.

There is another trading tool for oil price: PowerShares DB Oil Fund (DBO). This fund also holds oil future contracts, but somehow loses much less money on contango effect.

Suppose, you shorted 1000 shares of USO at 33.10 and bought 1500 shares of DBO at 19.29. Net difference is $4165. If you sold/covered them today at the close, USO at 36.25 and DBO at 24.88, you'd get additional $1070. Net gain of $5235 minus commissions.

There is a risk involved. If contango is replaced by backwardation (longer future contracts less expensive than near term ones), USO will outperform DBO. DBO is not as widely traded as USO, and there isn't much information evailable about it, so there are some unknown risks as well.

Full disclosure: at the time of publication author had no positions in DBO or USO. Positions can change any time.

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