Buying Oil - be careful with the Oil etfs, You may miss out on the first 50% of gains Options

[DrBubb]

Buying Oil - be careful with the Oil etfs
old title:
Buying Oil - why NOT to use the Oil etfs.
You may miss out on the first 50% of gains : Charts-on Advfn
==============================

(Many investors share a common misconception about how the rewarding the Oil etfs will be in an oil bull market):


more: http://maoxian.com/archive/using-etfs-to-t...e-price-of-oil/
(also look at: DIG, DUG, IEZ and HOU.t, HOD.t in Canada; OILB, in the UK)

Buying Oil - be careful with the Oil etfs

Many investors share a common misconception about how rewarding an investment the Oil etfs will be in a bull market for oil. Here's a recent discussion we had on GEI, my investor forum. I think it illustrates the common lack of understanding about the oil etfs actually work.

Many people are going to be disappointed if they fail to understand the impact of the present super contango upon future investment returns of these instruments. Here's a lightly-edited version of a discussion that took place in the last few days:

"Al":
I am bullish on oil at under $40, and have been looking to buy the dip soon.
I think there's alot of money to be made on Oil's rise, if we see it, by late 2009.

"Bob":
How do you go long oil at $40? Have you got a tanker to store it in?

Super Contango


Al:
I am talking about using one of the many oil ETFs that are available.

Bob:
You cannot truly "buy oil at $40" that way. You merely buy an etf whose price "relates" to Oil.
EXAMPLE:
Here's yesterday's Oil Futures Curve:
Feb.09 : $40.83
Jan.10 : $59.48
What sort of profit do you expect if oil hits $59.48 in Dec. (using the Jan10 contract as your price measure)?

Al:
For simplicity I am going to change those prices to $40 & $60, the difference between them is 50%.
So I might make 50%. Or using a 2x leveraged ETF that should be approaching 100%. Based upon
your real figures (for current futures prices) I would reckon at least 90%.

Bob:
Sorry - but that's not true.
Chances are: You will breakeven or lose money with USO, or one of the other oil etfs.
Here's why...

USO (to pick on the highest volume Oil etf) does not own any physical crude oil, it merely buys futures contracts...

The prices I have quoted above ARE THE CURRENT PRICES for WTI (as of xxx)
USO uses those contracts to hedge itself - and, since it must rolls its positions forward on a regular basis to prevent taking physical delivery, it is not easy to consistently do better than achieve the market prices.

Think of it as climbing a ladder. As each month goes by, USO sells one month's contract, and buys the next month forward. In the current market with its steep contango. there's a big premium to "roll forward" into the next available month. In other words, the space between the rungs is big, and it must pay up, to get onto the next month forward. In practice, management has some leeway, and they do not have to wait for the last days, or even the last month, to roll forward. But roll forward, they must, since they are not set up to take physical delivery.

Think about the impact this "rolling forward" behavior has upon USO's Net Asset Value.

Since USO has limited funds, when the the forward rungs in the price ladder are higher, it is going to have to buy only a smaller number of barrels each time that it rolls. So it might Buy March (at $46.07) and Sell Feb. (at $40.83)*. It is paying 12.8% more per barrel to roll, and so it will wind up owning 13% less oil, and there will be 13% less barrels backing each share of USO. This is why USO now trades at $32.37 per share, versus $40.83 per barrel for WTI. When it started, there was one barrel backing each share in USO. Now each USO share is backed by 0.703 barrels (using March's WTI price.) In addition, something that I am not factoring into these calculations is the cost of the transactions (small) and the administrative cost of running USO (not small.) That is why I say that you might even lose money with USO if the oil future curve stayed as it is now.

In an upwardly sloping "contango" market such as we have at present, the "barrels per share" backing for USO diminshes, while in a downwardly sloping "backwardated" market, the number of barrels backing each share will increase over time. Thus, in markets like this, it is perhaps better to buy shares of companies with oil "in the ground" so they do not need to pay the high forward premiums (which tend to be realted to storage costs.) Alternatively, to buy shares in companies whose valuation is historically associated with the oil price (like oil service stocks, and some other "oil-realted stocks" that I am following.)

Do you see why I buy "oil related" securities, rather than USO, the Oil etf ?

============
* Note:
WTI Futures Curve, "like a ladder"
---------------------
Feb. 2009 $40.83
Mar. 2009 $46.07
Apr. 2009 $49.11
May 2009 $51.21
Jun. 2009 $52.75
Jul. 2009 $54.13
Aug 2009 $55.22
Sep 2009 $56.17
Oct 2009 $57.04
Nov 2009 $57.87
Dec 2009 $58.69
Jan 2010 $59.48
======
source: http://www.nymex.com/lsco_fut_csf.aspx
Brent : https://www.theice.com/marketdata/reportcen...4&hubId=403

[chris ct]

I think post #1 was me.
I was able to buy the Feb Oil contract at ~$40.
I saw then that there was enormous (what I thought was "contango") difference in the Mar, Apr.. etc prices. I did ask at the time what people thought may happen to this gap as we got near the Jan-16th end-date for "Brent crude Feb09".
I could see then that Mar-09 was trading $2 above Feb.

This, I suppose is why shell are storing oil in tankers etc. Contango.

[DrBubb]

STORAGE IS FULL everywhere.

Which is why the price tends to dive as it approaches spot.
People understand that oil looks "cheap", and they like to have a medium or longer term
oil price exposure, but when it comes to "spot", there's a big glut of physical oil everywhere.

Here's the historical RATIO of USO -to- WTI:
It tells us when the market was in Contango (ie upward sloping), and when it was in Backwardation
(ie oil is cheaper in the future,)

WTI Crude

Major Oil Co's (XLE) to WTI ratio


Notice that the market shifted from Contango to Backwardation in Q3.2007, as oil prices shot
up through $70. Where's the long term price now??

Dec.2009: $58.69
Dec.2010: $65,86
Dec.2011: $69.37
Dec.2012: $71.64
Dec.2013: $73.76 - this is about HALF the July 2008 high of $146 !
Dec.2014: $75.37
Dec.2015: $76.92
Dec.2016: $78.23

Also, Notice that the XLE-to-WTI ratio shot up as crude fell below $70. I reckon that the oil shares are being priced off the long term price of crude rather than the spot oil price.

[lupercal]

I'm very confused now. What is a good way to invest about 5K on black gold for 2 years.
An oil related security will be effected by the downturn in the stock market wont it? E.G. Exon or BP?

I'd like to wait till the next black [insert weekday] and buy then. But if I wait too long sterling will be worth not much but I'm lookng at diversifying and dont want

[DrBubb]

L.
Check out the XLE-to-WTI chart & comment that I have added (above) since your post:

"Also, Notice that the XLE-to-WTI ratio shot up as crude fell below $70.
I reckon that the oil shares are being priced off the long term price of crude rather than the spot oil price."

The Ratio of OIH-to-WTI Crude is tighter:


Month----: WTI-- : Ratio= using OIH of 79.23
Feb. 2009 $40.83 : 1.94
Mar. 2009 $46.07 : 1.72
Apr. 2009 $49.11
May 2009 $51.21
Jun. 2009 $52.75 : 1.50
Jul. 2009 $54.13
Aug 2009 $55.22
Sep 2009 $56.17 : 1.41
Oct 2009 $57.04
Nov 2009 $57.87
Dec 2009 $58.69 : 1.35
Jan 2010 $59.48 : 1.33

[nicejim]

Thanks for this Bubb. Is there an ETF of oil companies, for those of us with insufficient funds to diversify economically?

(or perhaps an Investment Co is better?)

[Pixel8r]

Thanks, for pointing this out DrBubb. It was something I was starting to work out for myself after my short dabble in LOIL recently.

After holding LOIL for around a month, I sold out for a small profit (15%) and realised that it was not as straight forward as it seemed. You will note that I made a post mentioning that I thought LOIL should only be used for short term trading, rather than long term holding. This is due to the losses you make with the current contango situation.

I have decided that holding OIL EFTs is not a way to make money for the long term. I would welcome any of your knowledge on how to benefit from the current oil situation.

Likewise I sold my LOIL today, for a small gain (15%). It does seem to be a tool to be used only for the short term spikes. Think I will try it again if we get to $30pb.

[lupercal]

Cross posting. While you sent the last one Dr B, I had look at these

Inpex looks good after falling 12% last week.

Chevron Corp went down too.
http://finance.google.com/finance?q=NYSE:CVX

BP down
http://finance.google.com/finance?q=NYSE:BP

Total down
http://finance.google.com/finance?q=NYSE:TOT

There's a lot of them. I'll try a pick and mix approach.

[DrBubb]

Thanks for this Bubb. Is there an ETF of oil companies, for those of us with insufficient funds to diversify economically?
(or perhaps an Investment Co is better?)

The etf for the Major Oil Co's is XLE - the one I used in the chart above.

I prefer using Oil Service etf / OIH, or one of its components- see chart etc. above.
I am adding some ratios to the WTI strip of contracts.

From above:
Jun. 2009 $52.75 : 1.50

If you buy OIH at $79.23 and hold until May, it will be like buying Crude ar $52.75 and
a Ratio to OIH of only 1.50 - that's cheap ! Look at the Chart for the Ratio.

So you see, that's how I look at it. I think OIH is an Oil-related exposure, which is substantially cheaper
than Crude. Because although you can buy spot crude at about $40 now, there's no way (for the average
person) to store it. And you will find you have to roll it, at a higher and higher cost.

[DrBubb]

(from the OIH Signal thread):

OIH stocks may be a good BUY on Monday, if it can hold OIH-75. : OIH-10d-chart

Friday's action was:
OIH: 79.23 Change: -5.22
Open: 84.00 High: 84.25 Low: 78.67
Volume: 10,648,000
Percent Change: -6.18%

Friday's low may be good enough. Click on chart, above

The larger components are: (at 3/2007 were):
SLB / Schlumberger : 10.41%
RIG / Transocean.... : 10.08%
HAL / Halliburton....... : 9.52%
BHI / Baker Hughes... : 9.52%
GSF / ...................... : 8.44%
DO / Diamond Offsh... : 6.10%
NE / Noble Corp........ : 5.93%

[nicejim]

The etf for the Major Oil Co's is XLE - the one I used in the chart above.

I prefer using Oil Service etf / OIH, or one of its components- see chart etc. above.

Thanks, I'll consider those.

[The Undertaker]

Does this apply to oilb as well?

Thanks for all the advice.

[Pixel8r]

(from the OIH Signal thread):

OIH stocks may be a good BUY on Monday, if it can hold OIH-75. : OIH-10d-chart

Friday's action was:
OIH: 79.23 Change: -5.22
Open: 84.00 High: 84.25 Low: 78.67
Volume: 10,648,000
Percent Change: -6.18%

Friday's low may be good enough. Click on chart, above

The larger components are: (at 3/2007 were):
SLB / Schlumberger : 10.41%
RIG / Transocean.... : 10.08%
HAL / Halliburton....... : 9.52%
BHI / Baker Hughes... : 9.52%
GSF / ...................... : 8.44%
DO / Diamond Offsh... : 6.10%
NE / Noble Corp........ : 5.93%

All the components appear to be approaching GIP points, am I correct in thinking that?

I cannot buy OIH within my ISA in the UK, so am thinking I may take stab at some of the components. Any in particular you like?

[DrBubb]

All the components appear to be approaching GIP points, am I correct in thinking that?
I cannot buy OIH within my ISA in the UK, so am thinking I may take stab at some of the components. Any in particular you like?

i will let you know when i finish my research.
i made a nice profit already, trading calls on BHI from my Nov. Call on the "oil low" thread.
(right now, id be inclined to use BHI again or maybe DO)

Here's a useful recent posting from that thread:

That's a very good explanation, thanks.
So only use USO when oil is in backwardation or when there's a very shallow contango curve?

YES, that's it. And maybe in these circumstances:

+ If you want to trade a very brief upswing in the price, or
+ If you want to short it in a contango market, since USO should slide it WTI trades sideways long enough

I am look at a strategy where I go long OIH (or maybe calls on OIH) and go short USO (or buy puts.)
I reckon that has a good chance of making money on a 3 month to 12 months time horizon.
But I want to do more research before pulling the trigger on this.

[DrBubb]

Does this apply to oilb as well?
Thanks for all the advice.

Sure. Although I think the contango in Brent is somewhat less steep,
since the spot price is higher.

I want to look at the Ratios between the various Oil etfs

(More later)

Here's an interesting segment from the Joe Dancy article on "super contango":

..

"A contango condition is not the normal situation in the futures markets. Normally prices in the future are lower than the current price (a condition known as ‘backwardization’ and is illustrated by the ‘one year ago’ line on the chart). And a ‘super contango’ (illustrated by the ‘yesterday’ line on the chart) where the spot market price is substantially lower than the price 12 months in the future is a very unusual event.

The super contango is most likely being fueled by the credit crisis and the need of companies to produce as much product as they physically can to generate cash. The contango situation would normally create an incentive to delay production to a future date, and generally supports upward pressure on short term prices as such production is delayed.

This condition has lead some larger companies to charter large crude oil carriers to use as storage facilities. Buying oil at spot ($42 a barrel roughly) while selling 12 month futures simultaneously (at $60 a barrel) yields a profit even after the cost of the charter and storage."

== ==

HOW DO YOU GET OUT of a contango situation?

Oil co's have a huge incentive to DELAY PRODUCTION, and eventually they will do that.
The new oil being delivered into spot will decline, and all that oil in storage will start to be consumed.
Until we see that, there is likely to be a "dive in price" as each oil future contract approaches spot.

[Catflap]

It was looking relatively straight forward the other day - now I'm not so sure. Perhaps I'll still put a small amount into the $ denominated oil EFT to see what happens and to learn.

[DrBubb]

It was looking relatively straight forward the other day - now I'm not so sure. Perhaps I'll still put a small amount into the $ denominated oil EFT to see what happens and to learn.

I would suggest:
+ Use DBO rather that USO or OIL*
+ Maybe: cut you investment in Half, and put the other half into OIH, which I expect will do better**

*For some reason, DBO has outperformed the other two, since oil moved into contango.

DBO vs. USO, OIL ... update : **DBO vs. USO, OIL, OIH

[Catflap]

I would suggest:
+ Use DBO rather that USO or OIL*
+ Maybe: cut you investment in Half, and put the other half into OIH, which I expect will do better**

I can't see any suitable ETF's for the UK investor, at least not with the broker I am with

[GTG]

For anyone with a Selftrade ISA these are some of the oil or oil related stocks which DrBubb has mentioned before (and a couple of other ones) which are tradeable online:

BHI Baker Hughes
DVN Devon Energy
HAL Halliburton
SLB Schlumberger
PGF.U Pengrowth Energy
PWT.U Penn West Energy

FWIW, if you do not find a stock or ETF listed after searching ST's database give them a ring as they will deal if as a result of your call they find the stock is crest settled.

[DrBubb]

... oil or oil related stocks which DrBubb has mentioned before (and a couple of other ones) which are tradeable online:
BHI Baker Hughes ...

This link : http://tinyurl.com/9tswfn
Will take you straight into a Stockcharts chart for BHI with my favorite settings pre-set.

If you put "BHI:$WTIC" into the window, you will get a chart showing the Ratio of BHI-to-WTI Crude.

Change the BHI to "OIH" or one of the other stocks, and you can get their ratios too.