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Despite Crude Rebound, Oil Investments Are Still a Bad Trade

Despite Crude Rebound, Oil Investments Are Still a Bad Trade

By    |   Tuesday, 22 March 2016 07:04 AM

Oil prices seem to have bottomed and are moving higher after a multi-year bear market.

Despite the possibility of future gains, many individual investors are unlikely to enjoy large gains in this market.

Oil trades in cash and futures markets. Individuals cannot participate in the cash markets where oil is bought by large users and refiners and sold by producers. Futures markets are accessible to individuals but involve more risk than stocks. In response to fears about futures markets, Wall Street created ETNs that allow investors to trade oil. Exchange-traded notes are backed by derivatives and carry greater risks than ETFs which are backed by stocks or bonds.

ETNs, like other Wall Street inventions, generate significant fees for their sponsors. United States Oil (USO), for example provides its manager with about $27.7 million a year in revenue based on its 0.72 percent management fee. Investors are assured of underperforming oil by at least this much. In reality, they will underperform oil by more because they are required to pay commissions and other trading costs even though these costs are not readily disclosed.

These costs can and affect performance. Oil is down less than 1 percent year-to-date while USO is down about 4.8 percent. The difference between the two numbers is known as tracking error and is unavoidable. The fund will always pay fees and will always be trading because USO is required to buy new derivatives every month. Unlike stocks, derivatives have an expiration date and USO is forced to replace expiring derivatives with new contracts. This can be an expensive process.

Recently, oil contracts expiring in two months cost almost 5 percent more than contracts expiring in one month. That guarantees a loss when rolling forward and that premium is another cost USO investors face. On average, that cost has been about 3 percent a year but can increase in volatile markets and also tends to increase in bull markets. In other words, as oil moves up the tracking error in USO is likely to increase.

Of course you could still gain 10 percent or more in USO as long as oil moves up significantly more than that.

When evaluating ETNs, it’s important to understand that you will not participate in the full move of a commodity and it’s even possible to lose money when the underlying commodity gains. Investors in USO learned that lesson the hard way in 2010 and 2011 when oil gained but their ETN lost money.
Michael Carr, CMT, is a subadviser to a mutual fund family and a chartered market technician. To read more Michael Carr, CLICK HERE NOW.

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Oil prices seem to have bottomed and are moving higher after a multi-year bear market.
oil, crude, price, invest
Tuesday, 22 March 2016 07:04 AM
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