Going Short the USO
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United States Oil (NYSEMKT: USO)
(The following write-up is an edited and abbreviated pitch pulled from the SumZero community.)
Recommended Action: Short
Current Price: $38.00 Target Price: $30.00
Source: Hedge Fund. New York, NY
Quick Background
United States Oil Fund is an ETF that is supposed to track the price of a barrel of oil in the USA (WTI). In theory, it is an interesting financial product that allows investors to easily invest in (or bet against) the future price of oil. It is mostly owned by retail investors that view it as a proxy for owning oil itself.
Like many Wall Street products, USO is a wolf in sheep’s clothing. Because it uses future contracts to gain exposure to the price of oil, it suffers from “Roll Decay,” which makes it consistently lose value over time. Simply put, it does not accurately track the price of oil and is all but certain to cause large losses over time to its investors. Given enough time, it will go to zero.
In our research, we went back and calculated how quickly USO should have lost value due to roll decay (about 5% per year). In reality, it ended up losing value about twice as fast (about 10% per year) -- these are approximate figures, not exact numbers. To be honest, we don't exactly know why it loses value so quickly, but it clearly does -- over many years. Possible explanations include: high trading costs, front running by traders when USO needs to roll their future contracts, poor timing when rolling future contracts, hidden operating costs, etc.
Recent Performance
Since July 2006, the price of oil has increased from about $73.5 a barrel to about $98.7 per barrel, a 34% increase.
As the chart below shows, since July 2006, the price of USO has declined from about $69.5 per share to about $38.2 per share – a 45% decline. So instead of earning 34%, investors in USO actually lost an astonishing 45%. Very clearly, USO did not track the price of oil and caused large loses to investors even tough the price of oil increased.
Risks
The biggest risk is a spike in oil prices, possibly due to tensions or a war with Iran. We think the risk of an oil price spike due to war is not great, since Iran closing the straights of Hormuz would be suicidal for the Iranian regime.
Another risk is that WTI futures might go into backwardation, which would temporarily negate part of the short thesis. In fact, this is close to happening right now. This contango implies a loss of about 2% per year - not much, but as mentioned, our experience is that USO actually declines much faster than the slope of the futures curve would indicate.
Action
We are short USO, both directly and using options. We expect to make money on this short position. In addition, we like that our short USO position acts as a natural hedge to some of our investments in commodity producers. We think this is a good long-term short, and is especially attractive as a hedge for long positions that would benefit from oil price increases.
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