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A Holiday Treat for Oil Investors

Over the holiday break, there was a significant change in the price of oil futures, giving these ETF buyers a lot to be thankful for.

If you were busy getting ready for Thanksgiving last Wednesday, you might not have noticed—dare I say it?—an earth-shattering event. Well, maybe I’m overselling it, but it was something we haven’t seen for three years.

The oil market flipped into backwardation. 

Backwardation describes a futures curve in which nearby deliveries are priced higher than deferred contracts. On Wednesday, the January 2018 contract for light sweet crude oil settled at $58.02 per barrel while April futures posted a $57.78 finish. The previous day, January was pegged at $56.83 and April at $56.92.

So, what’s the big deal? Well, backwardation in a storable commodity market like oil typically bespeaks tight supplies. Oil often vacillates from contango—a rising futures curve with lower nearby and higher-deferred prices—to backwardation as a consequence of big supply shifts. The oil market last flipped—from backwardation to contango—in November 2014, following a series of positive oil supply shocks. 

We’re now coming out of a contango that spanned 774 trading days. The foregoing bout of continuous backwardation spanned 227 trading days. No small trends these.

You’d care about contango and backwardation if you owned oil exchange traded funds or notes. These products use futures to gain exposure to oil’s price. Since futures contracts expire, exposure can only be maintained by rolling positions from expiring contracts into forward months.  

Owning a fund such as the United States Oil Fund (NYSE Arca: USO) can make you a hater of contango. When the market’s in that state, each monthly roll could produce a negative yield as your ETF sells the nearby (lower-priced) future and buys the deferred (higher-priced) contract as a replacement. This drag explains an awful lot of the ETF tracking error.

If you hate contango, you ought to love backwardation. In an inverted market, rolling your fund’s long positions forward can produce incremental gains as the higher-priced nearby is sold and the lower cost back month is purchased.

 

 

Now, let’s think about that for a moment. Back in August, we examined contango’s impact on three oil ETFs and noted it was felt most keenly by United States Oil. But what worked against USO in a contango can now work for USO. It’s possible, in fact, for USO to actually outperform spot oil while the market’s inverted.

Wouldn’t that be a holiday treat?

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