Pierre Andurand's Presentation on Oil: Sohn London Conference

We're posting up notes from the Sohn London conference 2017.  Next up is Pierre Andurand of Andurand Capital who gave a presentation on oil.


Pierre Andurand's Sohn London Presentation

Oil prices will go much higher than consensus. In the last 18 months there has been a lot of negative hype about oil prices. The two most discussed factors have been US shale production and electric vehicles. US shale has been called the internet of oil.

Demand for oil has rarely been as strong as it is today. Demand is as high as it was 10 years ago when there was a lot of talk about the super cycle and demand growth. New oil discoveries are at all-time lows.

Supply will peak before demand at current oil prices. Oil demand will peak sometime between 2027 and 2035, much later than the consensus view. The supply of electric vehicles will be constrained by a shortage of batteries.

Supply will peak in 2020. Oil discoveries peaked in the 1960s. They stabilised in the 1990s making a lower peak with US shale discoveries in the early 2000s but they have been declining since then. We are finding 10x less oil than we were 20 years ago. Global reserves are going down fast. We have a 100bn barrels (or 10% less) of reserves than we had 10 years ago when everyone was worried about peak oil. The largest declines have been in ex-US small oil fields. The rate of decline will quicken and supply will be less than expected.

Nobody wants to invest in oil projects that take 6 years to come to market and 20 years to make a profit. Against expectations, US production is flat this year. Productivity per well will go down. We could need $100 a barrel oil to mitigate the fall in supply.

If OPEC goes back to full production, there would still be a deficit of half a million barrels per day. Inventories are low.

OPEC is unlikely to go back to full production leaving a deficit of 1m barrels per day. In this scenario oil could easily reach $80 per barrel.

If there is a geo-political event in the Middle East like a major war, we could see $150 per barrel. There are a lot of potential downside risks to supply. In-fighting in the Saudi Royal Family.  An Iran-Saudi war. The US could impose sanctions on Iran which could push oil price oil prices up.


Be sure to check out the rest of the presentations from Sohn London 2017.

Pasco Alfaro's Miura Global Management Buys Crude Oil Via United States Oil Fund (USO)

Pasco Alfaro's hedge fund Miura Global Management recently filed a 13G with the SEC regarding shares of the United States Oil Fund (USO). Due to activity on June 29th, 2010 Miura now shows a 7.5% ownership stake in the exchange traded fund with 4,241,000 shares. This is a brand new position for Alfaro's hedge fund as they did not own shares back on March 31st, 2010 when first quarter portfolio disclosures were made.

What's interesting here is the fact that the fund has used an exchange traded fund as a proxy for investing in oil rather than directly playing oil futures. Before assessing further, remember that since this is a commodity related investment rather than a stock, the rationale behind the pick might not be what it seems. This could simply be a bullish directional bet on crude oil (in part possibly spurred on by the Gulf oil spill). At the same time, Miura could be using this vehicle as a hedging instrument as they often have various alternative energy plays in their portfolio.

Either way, the fact that they hold such a concentrated position in this crude oil exchange traded fund (USO) is intriguing in and of itself. This is by far the largest pure crude oil position we've seen from the equity focused hedge funds we cover. In the past, we've detailed how to invest in crude oil via exchange traded funds. While that comparison highlights the pros and cons of the various vehicles available to investors, it's surprising to see a prominent hedge fund investing such a large sum in a somewhat flawed exchange traded fund. There are numerous negative aspects to using USO as a proxy for oil, many of which we outlined via an in-depth piece, how contango affects crude oil ETF's. Needless to say, the fact that USO merely buys front month crude oil contracts over and over leaves much to be desired.

So while we don't quite know the exact rationale behind Alfaro's investment for his hedge fund, we do know that USO is a vehicle more-so suited for near-term trading rather than investing longer term. Maybe more than anything they might have selected USO purely for its liquidity as other oil funds are far less liquid on a daily trading basis. We'll have to see if we can glean further information regarding their investment purpose (directional versus hedge) and their investment timeframe.

This is the first time we've detailed portfolio maneuvers from this hedge fund so let's get some background. Miura Global Management is a long/short equity hedge fund founded in 2004 by Pasco Alfaro and Richard Turnure. While Alfaro still manages the firm, Turnure left to pursue an alternative energy endeavor after spearheading many of Miura's investments in that space. Miura grew from $5 million in assets under management to upwards of $3 billion. The hedge fund focuses on cutting edge research, multifaceted risk management, and non-correlated returns. Miura Global is a 'Tiger Seed' hedge fund because it was seeded by legendary Tiger Management hedge fund manager Julian Robertson. As such, the fund is a part of the 'Tiger hedge fund family tree'.

Taken from Google Finance, the United States Oil Fund is "a limited partnership. USOF is a commodity pool that issues limited partnership interests (units) traded on the NYSE Arca, Inc. (the NYSE Arca). The Company’s general partner is United States Commodity Funds LLC (the General Partner) and is responsible for the management of USOF. The investment objective of USOF is for the changes in percentage terms of its units’ net asset value (NAV) to reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract on light, sweet crude oil traded on the New York Mercantile Exchange (the NYMEX)."

For the latest investments from top managers, head to our daily hedge fund portfolio tracking series.

Crude Oil Technical Analysis Video

The guys at MarketClub are back with another great video and this time they're talking about crude oil, which has had a heck of a year so far. They take a look at the chart using technical analysis and talk about the current trend and where it is headed next. So, check out their excellent video on crude oil.

Also, if you missed them, they've done some great analysis on the best inflation indicator and then separately on gold as well. These guys give great technical analysis commentary and we highly recommend checking the videos out.

How to Play Crude Oil Using ETFs & ETNs: A Comparison of USO, DBO, & OIL

The following is a Guest post on MarketFolly.com.

'tradefast' is the nickname of an independent equity trader who has more than 20 years of market experience at a major financial institution and 2 hedge funds. He now trades for a private investment fund, using a combination of both fundamentals and technicals. (He's our kinda guy).

Last week, he sat down to explain how contango affects the crude oil ETF's and ETN's that many investors and traders usually play, including USO, OIL, & DBO. This next piece is a follow-up post to that topic. So, before beginning, make sure you check out: How Contango Affects Crude Oil ETFs & ETNs.

Next, he takes a look at how to play crude oil using those same ETFs & ETNs. He writes,

Objective

This article provides some straightforward insight as to how a retail trader/investor can implement a directional play on the price of crude oil. Included is a discussion of the manner in which the forward market for crude oil can cause crude oil ETF returns to deviate from spot market returns. This article is not intended to be authoritative, comprehensive, or highly technical. It is simply a compilation of previous discussions on the topic (with some added elbow grease and my version of common sense). Readers should be aware that much of the material in this article has been discussed previously here and here. Certain elements of this article are pulled directly from these sources.

Note

When I first wrote about the effects of forward curves on crude oil ETFs, the crude market was in steep contango and the discussion attracted widespread attention. More recently, the crude curve has flattened somewhat and it may appear to some individuals that the curve shape has become less of an issue to retail speculators. I have a different view. I believe that sharp volatility in the shape of the curve makes it imperative that retail crude speculators understand how curve adjustments can affect their positions. This topic is not dying, but rather garnering added importance.

Introduction - Retail Investors Cannot Trade Spot Crude Oil

I have a friend with fairly extensive stock trading experience who generates most of his technical market analysis using the S&P 500 futures contract. When it comes time to transact, however, he will swing over to the cash market and trade an ETF such as SPY (S&P 500) or a leveraged ETF such as SSO (2x the S&P 500) or SDS (2x the inverse of the S&P 500 - a double short). Although he and I share the same trading objectives (to capture a directional movement in the S&P 500), I choose to generate my technical analysis using the precise instrument which I expect to trade. In my case, SPY (or SSO or SDS if I desire leverage). I am confident in my approach because I know the instrument I am trading exhibits an extremely tight relationship to movement in the S&P 500 cash market. Simply put, I trade SPY because is a highly dependable proxy for replicating the spot market of the S&P 500.

Unfortunately, traders or investors wishing to implement a directional play on crude oil lack access to a tradeable instrument which tracks spot crude oil in the same manner that SPY tracks the S&P 500. Instead, we must choose from an array of instruments which are structured with the intent of tracking crude prices, but with flaws relating to the fact that crude oil (unlike the S&P 500) is a physical commodity for which spot trading is limited to those who can transport, store, or produce crude oil.

Crude Oil Futures – The Curve

Fortunately, despite our lack of access to the crude oil spot market, there is a highly liquid market for futures contracts which reference crude oil. And, the price of these contracts exhibits volatility which generally resembles the movements in the spot market. Many traders transact directly in crude oil futures contracts, electronically or in the futures pit. These traders rely on the fact that they will never have to physically handle the commodity itself. They can simply close out their futures positions prior to expiration and net out the difference between their entry and exit price.

The fact is that trading in crude oil futures (which expire monthly) is spread out over several months, even years. And, the price of crude for delivery at future expiration often varies substantially from month to month. At times, prices in future delivery months are progressively higher than in the nearest delivery month (contango). And, more often than not, the opposite is true (backwardation). Many futures traders have specialized knowledge of the day-to-day shifts in supply and demand fundamentals and they are comfortable projecting price movements at specific points along the forward curve. The typical retail investors probably lacks the skill-set needed to profitably exploit forward curves in a sophisticated manner.

Introducing Crude Oil ETFs/ETNs

For the retail crude oil speculator who is incapable of trading crude oil futures, there are tradeable ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) which employ futures contracts in pursuit of the general objective of “tracking the price of crude oil”. A typical crude oil ETF will hold long positions in WTI (West Texas Intermediate) crude oil futures contracts. As with most futures traders, these funds employ leverage, putting up a small portion of the capital to buy the contracts. The rest of the fund’s assets are invested in money market instruments which generate a modest amount of interest income for the fund.

ETFs – The Roll

In theory, the existence of crude oil ETFs enable individuals to implement a single equity trade to express a view that crude oil prices will either rise or fall in the future. Unfortunately, this objective is compromised by the existence of a forward curve in the crude oil futures market.

Because of the forward Curve, any ETF referencing crude oil cannot simply rely on ownership of the existing front month (closest to expiration) futures contract. To remain invested at all times, it must periodically sell its existing futures holdings and roll its exposure to a futures contract expiring in a more distant month.

ETFs – Return Components

With crude oil ETFs, the technical result of utilizing crude oil futures for the NAV (net asset value) return is dependent on three variables: 1) changes in the spot price of crude oil, 2) interest earned on un-invested cash, and 3) the ‘roll yield’ – which is a function of the spread between the price of the contract being sold and the price of the contract being entered. In contango markets, the roll yield will be negative because the fund must pay up to enter the more distant contract, and the opposite is true in backwardated markets. Furthermore, the precise timing of the forward roll can have a material impact due to the propensity of the expiring contract to experience high volatility in the days immediately prior to expiration.

Roll Yield – ETF Return Illustration

Let us consider the case of a hypothetical crude oil ETF which provides exposure to the front month crude oil futures contract, with the exposures rolled forward as expiration approaches.

To illustrate the concept of the roll yield, assume that the 2009 spot return on crude oil is +20%. But, assume that persistent contango in the market results in a cumulative roll yield of -15 %. In these circumstances, the combined return of a crude oil based ETF might be in the ballpark of +5%, a far cry from the +20% return generated in the crude oil spot market.

As illustrated, contango in the crude oil market may cause ETF returns to lag spot market returns. Not surprisingly, a flat/stable forward curve would result in a minimal roll effect. On the other hand, a backwardated curve may cause the ETF to outperform the spot market.

Roll Yields – A Source of Tracking Error

The variability of roll yields coupled with the shifting slope of the forward curve should dispel any notion that the return on crude oil ETFs will track the spot market of crude oil in a predictable manner. The managers of the crude oil ETFs and ETNs are fully aware of this issue and they make no claims regarding their ability to replicate spot crude returns. They merely claim to attempt to track a return benchmark that is comprised of crude oil futures contracts, thereby providing traders/investors with some ability to participate in directional movements in the price of crude oil. (Note: This situation is analogous to an issue which exists with certain leveraged (non-oil) ETFs which have proven to be extremely deficient in terms of tracking their benchmark indices in volatile markets. These instruments have strictly adhered to their stated strategies and objectives, but have failed to achieve the imaginary objectives of many careless traders.)

ETFs/ETNs – Examining the Fine Print

Included below is some language directly out of the prospectuses of some of the more popular crude oil ETFs and ETNs. Notice that the managers willingly acknowledge the issues related to forward curvature and the roll yield impacts on returns. This segment of analysis will focus on the three most popular crude oil instruments in existence today: an ETN (OIL) and two ETFs (USO & DBO). Many of the issues raised herein are applicable to all crude oil ETFs and ETNs, although leveraged ETNs (such as DXO) involve complications which are not analyzed here.

ETF versus ETN – Counterparty Risk

No discussion of crude oil ETFs would be complete without some mention of the important difference between an ETF (Exchange Traded Fund) and an ETN (Exchange Traded Note). With an ETF, holders are secured by the assets of the fund, so the credit worthiness of the fund manager firm is not a relevant consideration. If the manager collapsed into insolvency, the ETF would be unaffected, except for the possibility of a change in management (which is not an important consideration in the case of a fund which is passively managed to match a specific benchmark). In contrast, owners of an ETN are unsecured creditors who receive a mere ‘promise to pay’ equivalent to the value of the underlying assets. Let's simplify this distinction: If a given ETF and a given ETN have the same exact net asset value (NAV), it is conceivable that the ETN could be worth less than the ETF if the manager of the ETN asset pool experienced a level of financial distress which resulted in a material downgrade of the credit quality of the manager’s bonds. Given that most ETN managers are financial institutions with challenging balance sheets, this risk is worthy of consideration.

In a worst case scenario, the ETN manager could face an abrupt insolvency and default on the ETN. This risk, often referred to as counter party risk, is similar to the risk that credit default swap (CDS) holders faced when Lehman Brothers and AIG encountered insolvency. We, as rational individuals, do not buy insurance from high risk insurers. And, as such, we should think similarly about owning ETNs issued by high risk managers.

US Oil Fund (USO)

USO is a standard crude oil tracking ETF that utilizes a strategy resembling the hypothetical ETF analyzed earlier in this article. Accordingly, USO entails all of the risk factors related to the use of crude oil futures as a tracking mechanism for crude oil prices. As with all ETFs, the objectives, the portfolio structure, and the major risk factors are clearly disclosed in the prospectus.

From the ‘risk factors’ section of the USO prospectus,

"in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return."

Notice how they warn that USO may experience a negative roll yield which may cause the NAV of USO to deviate significantly from the spot price of crude oil. Is there historical precedence for USO deviating from spot oil by a material amount? As it turns out, the answer is ‘yes.'

"During the past two years, including 2006, these markets have experienced contango. This has impacted the total return on an investment in USOF units during the past year relative to a hypothetical direct investment in crude oil. For example an investment made in USOF units on April 10 and held to December 31, 2006 decreased, based upon the changes in the closing market prices for USOF units on those days, by 23.03%, while the spot price of crude oil for immediate delivery during the same period decreased 11.18%."

The only logical conclusion is that USO is not a direct play on the spot price of crude oil. It is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (or, the slope of the futures curve).

Power Shares DB Oil Fund (DBO)

DBO is different from USO in that its managers utilize specialized strategies intended to mitigate the effect of roll yields on returns. As with USO, the prospectus for DBO directly addresses the issue of roll risk. In the case of DBO, however, the manager is not passive about accepting a negative roll yield in a contango market. In the words of the manager,

"Rather than select a new futures contract based on a predetermined schedule (e.g., monthly), each Index Commodity rolls to the futures contract which generates the best possible ‘implied roll yield.’... [The manager] is able to potentially maximize the roll benefits in backwardated markets and minimize the losses from rolling in contangoed markets."

I think it is fair to point out that the active approach being utilized by DBO presents both opportunities and risks in relation to the more passive rule-based approach used by USO. It is certainly conceivable that, by employing their optimization model, DBO will exhibit improved roll yields and better returns than USO. But, as with all things financial, the DBO model may backfire due to faultiness of imbedded assumptions. If DBO’s approach were full-proof, it is probably fair to conclude that an arbitrage opportunity might exist whereby profits could be generated by pairing a long position in DBO with a short position in USO. At this juncture, I am extremely hesitant to advocate such a strategy. Advanced readers wishing to gain a better understanding of DBO’s optimization approach may benefit from this link.

IPath S&P GSCI Crude Total Return ETN (OIL)

OIL is structured as an ETN issued as an uncollateralized obligation by Barclays Bank PLC. It is a financial institution that can be regarded as vulnerable to rising default risk in the current environment. As with USO and DBO, OIL is managed with the objective of tracking WTI crude oil prices by trading in crude oil futures (rather than the physical commodity).

OIL uses a specific benchmark to guide its futures trading activity: a crude oil index devised by Goldman Sachs. As with most index funds, OIL’s objective is to minimize the performance tracking error in relation to the index. OIL is not intended to perform better or worse than the index. The composition of the index, by design, can include any of the crude oil futures contracts which expire within three months. At present, however, the only contract used to calculate the index is the front month contract (which expires three business days prior to the 25^th of the next calendar month).

OIL’s roll strategy is formulated and it is unique from that of DBO and USO. But, the differences in relation to USO probably do not have a material economic effect. In particular, holdings of the front month futures contract are rolled over a five day period commencing on the fifth business day of the month. Essentially, this means that OIL will have completed its roll approximately two weeks before front month expiration. (Note: USO rolls two weeks prior to expiration).

In essence, OIL is more similar to USO because the roll strategy is formulaic, and not intended to minimize the effects of negative carry in a contango futures market (or maximize the benefits of backwardation). But, this similarity is also offset by the fact that OIL carries material counterparty risk since it is an ETN, while USO and DBO do not (since they are ETFs).

USO Versus DBO Versus OIL - Expenses and Liquidity

The volatility of these instruments is so high that expenses have a relatively minimal impact. But, for frugal and/or longer term investors, the following information may be relevant:

Annualized expense ratios:

• USO 0.86%

• DBO 0.54%
  

• OIL 0.75%
  

Empirical Data – Historical Price Returns

It is unwise to draw any specific conclusions from this information, but a quick examination of the recent market returns of USO, DBO, and OIL reveal the following facts:

Year-to-date price returns (thru 1/24/09):

• USO -2.9%

• DBO +1.1%
  

• OIL – 7.9%

Although inconclusive, the material disparity between the return of USO and OIL is potentially due to the fact that OIL is an ETN issued by Barclays – a Bank that has suffered from extensive credit quality impairment in recent days.

Returns, 2008 peak to current:

• USO -72%

• DBO -65%
  

• OIL -75%

Further assessment of the relative returns of these instruments can be found here.

Conclusion

Considering the following factors:

1. Counterparty risk
2. Futures roll strategy (and roll yield)
3. Liquidity and expenses

USO has no counterparty risk and no active management risk. DBO has no counterparty risk but has inherent risks and opportunity related to the active management of the roll. Lastly, OIL has material counterparty risk. I currently favor USO as the instrument to express my directional views on crude oil over the other two instruments DBO and OIL.

Thanks to 'tradefast' for the excellent in-depth overview of crude oil ETFs & ETNs. We think he has highlighted some excellent points that any trader or investor should know before using these vehicles to speculate on crude oil. If you haven't already, make sure you check out: How Contango Affects Crude Oil ETFs & ETNs. For additional coverage on crude oil, check out the recent slide presentation: Cheap Oil = Over. Also, we've commented on cheap oil, and have covered energy trader Eric Bolling's latest oil trades and thoughts here.

Lastly, you can follow tradefast on Twitter, and catch his thoughts on his blog.

How Contango Affects Crude Oil ETF's and ETN's (USO, OIL, DBO)

The following is a Guest post on MarketFolly.com. Note this is part of a 2 article series in which we also examine how best to play crude oil via the various ETFs/ETNs. Below, you'll find the article relating to how contango affects these investment vehicles. In a follow-up article, we compare the crude oil investment vehicles.

'tradefast' is the nickname of an independent equity trader who has more than 20 years of market experience at a major financial institution and 2 hedge funds. He now trades for a private investment fund, using a combination of both fundamentals and technicals. (That sounds like our kinda guy!)

He sat down to explain how contango affects the crude oil ETF's and ETN's many investors and traders usually play, including USO, OIL, & DBO. He writes,

"The US Oil Fund (Ticker: USO) holds long positions in West Texas Intermediate crude oil futures contracts, and rolls these contracts forward each month. Like most futures traders, USO buys futures with leverage, putting up a small portion of the money to buy the contracts. The rest of the money is invested in Treasuries, which generates interest income for the fund.

Three factors play a role in determining the performance of USO: 1) changes in the spot price of crude oil, 2) interest income on un-invested cash, and 3) the 'roll yield'. The first two factors are easily understood, but the third factor, 'roll yield' should be examined further in order to determine the extent, if any, to which traders of USO will be surprised by its performance in relation to spot crude oil.

First some background: Oil futures are available for each month of the year, so you can buy a futures contract right now which gives you the right to buy oil in February 2009, March 2009, April 2009, and so on. Currently, the price of oil in February 2009 is less than the price of oil in April 2009, a condition which is referred to as 'contango'. (If the opposite were true, the market for crude oil would be in backwardation.) Most commodity funds, including the US Oil Fund (USO) buy what is called the 'near month' contract and, because they do not want to take physical delivery of the commodity, they sell the current month's contract before it expires and buy into next month's contract. This process is called 'rolling forward', and it can result in the ETF paying up if the forward month contract is higher than the current month (contango), or cashing out if the opposition condition exists (backwardation).

To investigate the issue, I read through the 'risk factors' section of the USO prospectus. The following is relevant:

in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.

In essence, the USO prospectus is warning traders that USO may experience a negative 'roll yield' which may cause the NAV of USO to deviate significantly from the spot price of crude. Is there historical precedence for USO deviating from spot oil by a material amount? As it turns out, the answer is 'yes'.

During the past two years, including 2006, these markets have experienced contango. This has impacted the total return on an investment in USOF units during the past year relative to a hypothetical direct investment in crude oil. For example an investment made in USOF units on April 10 and held to December 31, 2006 decreased, based upon the changes in the closing market prices for USOF units on those days, by 23.03%, while the spot price of crude oil for immediate delivery during the same period decreased 11.18%

The conclusion, at this stage of analysis, is that USO is not a direct play on the spot price of crude oil - it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (the slop of the futures curve).

For a trader who is long USO, my instinct is that maintenance or aggravation of the contango in crude oil will cause impairment of the value of USO in relation to spot crude - whereas, any mitigation of the contango situation (including a shift to a flatter curve or backwardation) will enhance the performance of USO.

I plan to study this issue more extensively. But, in the mean time, I will not consider USO to be a good proxy for the spot price of crude oil - and I will be particularly leery of participating in USO for anything other than a short term trade."


'Tradefast' highlights an issue that many have overlooked or just not taken the time to research. Many perceive that USO is the "best way to play oil" since it's the front-month contract. But, as he points out, there are some issues with this ETF, depending on how crude oil is trading in the front month and beyond. So, as always, read the prospectus of each fund you're trading or investing in. It's important to understand what exactly it is you're dealing with.

In the comments section of his original article, he goes on to address similar issues in other crude oil ETF's and ETN's. Regarding ticker OIL, he writes,

"Here is a link to the prospectus for OIL, the IPath crude Oil ETN.

The 'contango issue' is discussed on PS-10. Short answer: yes, a contango market in crude oil will result in negative roll yields - similar to USO.

Also, be aware that OIL is an ETN (exchange traded note), rather than an ETF (exchange traded fund). With ETNs, you are an unsecured creditor of Barclays (the issuer of the note), so you have credit risk overlaid on the risk of the commodity.

In a former life, I used to enter into total return swaps on various indices with Lehman as the counterparty. I halted this practice long before LEH became a troubled credit. My sense is that the popularity of ETNs have fallen in relation to ETFs, because of the credit risk.

I have no strong opinions regarding Barclay's default risk, but it might be worthwhile to consider that Barclays CDS widened by a meaningful 98 bps on Friday, and the stock declined 24%. Although the current CDS spread of 265 bps is not indicative of extremely high default risk, the level and direction are cause for some concern. (Barclays credit risk can be hedged with CDS, but this is a market for instititional investors - and shorting Barclays stock against a long position in OIL exposes the OIL holder to unacceptable basis risk. Ergo, I would prefer ETFs (such as USO) over this specific ETN (OIL)."

He also addresses the Powershares ETF: DBO, writing,

"I took a quick glance at DBO from PowerShares. In the prospectus, PowerShares notes the following:

Rather than select a new futures contract based on a predetermined schedule (e.g., monthly), each Index Commodity rolls to the futures contract which generates the best possible ‘implied roll yield.’ The futures contract with a delivery month within the next thirteen months which generates the best possible implied roll yield will be included in each Index. As a result, each Index Commodity is able to potentially maximize the roll benefits in backwardated markets and minimize the losses from rolling in contangoed markets.

My interpretation of this statement is that the manager of the ETF utilizes a certain amount of discretion with respect to the futures roll. If the forward curve were humped (i.e. backwarded to some point, and contango thereafter), a skillful manager might be able to take advantage. I do not claim expertise in this area, but my observation is that the current market in Crude Oil is in contango as far as the eye can see, and there does not appear to be any immediate advantage to having a selection of forward contracts with which to complete the roll. Also, keep in mind that with active management comes potential advantages (the manager may make a skillful maneuver) and potential risks (the manager may screw up and underperform the benchmark).

Currently, I am not commenting on the leverage associated with DBO, it is beyond the scope of this particular topic (contango effects on crude oil ETFs and ETNs)."

Great insight from tradefast. We definitely appreciate his effort to research and write about each of the various popular ways to play crude oil in equity markets. We feel this is an important topic that needed to be addressed, seeing how so many people trade or invest in these ETF's/ETN's without even blinking an eye. So, thanks again to tradefast for the guest post. Note that a follow-up article was also posted where we examine how to play crude oil via ETFs & ETNS as we compare the different vehicles such as DBO, USO, & OIL. You can view the article on how to play crude oil here.

For some of our coverage of crude oil, check out the recent slide presentation: Cheap Oil = Over. Additionally, we've commented on cheap oil ourselves, and have covered energy trader Eric Bolling's latest oil trades and thoughts.


You can follow tradefast on Twitter, and catch his thoughts on his blog.

Richard Rainwater Bets on Oil

Taken from Fortune,

"Back in May, when oil was at $129 per barrel and rising, billionaire investor Richard Rainwater did something as prescient as it was shocking: He sold off all the energy stocks he owned.

Now he's making another bold move: He's betting on oil again.

A few weeks ago, when the price of oil tested a low near $90 per barrel for the first time in many months, Rainwater decided that he had found the right reentry point. "I reinvested back in the oil business, and it's worked out really well for me," he told me the other day. "I bought Exxon (XOM) stock under $75. I bought ConocoPhillips (COP) under $68. I bought Pioneer Natural Resources (PXD) under $50. I bought BP (BP). I bought Statoil. I made a big bet on the sector. I bought a lot of stocks back."

Considering Rainwater's incredible track record investing in the oil patch, that's big news.

Rainwater first made his reputation by greatly multiplying the Texas oil fortune of the Bass brothers of Fort Worth, with big bets on everything from the resurrection of Disney to the boom in cell phones. After going out on his own in 1986, he made bundles for himself in hospitals (by putting together HCA) and real estate (by forming Crescent Real Estate Equities). Then, in 1997, when crude was priced below $20 per barrel, he decided to make a huge bet on oil. He put $100 million into stocks and $200 million into oil futures. The wager netted him billions in profits.

As Time's Justin Fox reported in early June, Rainwater made the decision to close out his oil bet when the average price of gasoline passed $4 a gallon in the U.S. (and after he saw a reader poll on the Motley Fool Web site in which 77% of respondents said they were cutting down on gasoline consumption).

"I missed the very top by a lot," Rainwater told me. "That's okay. I'm always early. I sold after I got my first inclination that we had a problem with the demand side in America. I saw that we had a problem with the demand side and I sold out. But the stocks kept going up. And the price of oil kept going up. It went from $129 to $147 [on July 11]. But then it went from $147 back down to under $100, and that's when I bought back in."

Betting on increasing demand

Indeed, Rainwater is just as convinced as ever that oil prices are going higher in the long term. As he made clear in a Fortune story three years ago ("The Rainwater Prophecy") he believes that the world is facing a future shaped by scarce natural resources. His decision to sell out in May was based on a belief that oil prices had gone too far too fast, not that the bull market for oil - or for that matter, commodities of all kinds - has ended.

"I think we'll have a run on raw materials of all kinds because we've taught people all around the world how to play capitalism," he says, "and all those people want to live like Americans. But when you look at us being [4.5%] of the population and using 25% of the resource base, that can't go on. You can't extrapolate that out around the globe without there being price pressures on the upside. So there are price pressures in food. There are price pressures on raw materials of all kinds, including oil."

So with crude at around $100 and most of the stock market in chaos, he says oil companies look like a pretty good place for your money: "It's much more positive than the rest of the environment."

Given the volatility of the market right now, though, Rainwater is monitoring his new stock holdings closely. "I've already sold some of them," he told me. "Not all of them, but I sold some because they went way back up. I'm just playing cycles here, and the cycles are really powerful and fast moving. I bought ConocoPhillips for $68 and sold it two days later for $78. I don't think you can make that money in that short of a time unless you get lucky. And if I make that much money because I'm lucky, then I want out."

Rainwater may be lucky. But when it comes to oil, his instincts are more than good."

Source: Fortune

Oil... $120 is the make or break point. I expect a bounce

Wanted to touch on oil here since its such a big part of the markets these days. Currently, its pulling back and expectedly so. It was due for a pullback, but now we are approaching a very important make or break point: $120. As you can see in the chart above, every dip in oil has been a buying opportunity. And, interestingly enough, each dip has dipped all the way to the most recent peak and then bounced off that peak. Because, after all, that peak used to be past resistance. But, once we blasted through it, it became future support. For some reason I can't get my graphics to show up on the chart but do me a favor and just mentally draw a line horizontally across the $120 mark. There you will see where the pullback is headed. And, if look at the peak in the end of April, where does it sit? Yep, right at $120. Here's the deal, I'm short-term bearish on oil simply because it needs to pullback even more. All you hear about now is consumers complaining about $4 gasoline. So, with demand in the US (one of the biggest consumers of crude) decreasing, oil needs to pullback in price. Pure supply and demand economics. But, here's the catch. You can't expect that to happen because markets can remain irrational longer than you can remain solvent. So, I am *fully* expecting a bounce at $120 if we even get that low. Traders, speculators, you name it, they will all be rushing into this name on a beautiful technical bounce off of past resistance/now future support, as well as the moving averages. I've drawn the exponential moving average in red and the simple moving average in blue, since I know various people use various averages. But, this shows that both are right around $120. It's an imperative level and just wanted to make sure everyone had seen it. Not to mention, stochastics are oversold at current levels, implying a bounce. I don't usually look at stochastics on commodities in general, I typically use them just for stocks. But, its worth mentioning as it also backs up the argument for a bounce at $120.

So, buy oil on the dip to $120 for a trade at the very least. Place your stops below that and call it good. If it breaks below your stop then it's time to get short because then oil is heading lower and will have made a technical breakdown. You can play oil with ticker USO which is the US Oil Trust (think GLD but for Oil). Or, you could play it through the deep sea drillers like RIG, DO, ATW, etc. I'd recommend USO simply because the chart is identical to $WTIC (crude), so you've got clear entry/exit points. Whereas on RIG etc you've got to monitor the price of oil yourself and then set conditional buy/sell orders on those stocks once oil hits a certain price, triggering your order to buy/sell RIG or whatever oil company you choose to play it with.

Also, just wanted to throw in some commentary from oil greats Richard Rainwater and T. Boone Pickens. If you're unfamiliar with Rainwater, he's down in Texas and was famous for striking it big on heavy bets on Disney as well as heavy bets on the appreciation of the price of oil. He and Boone share the Peak Oil Theory belief. At any rate, Rainwater says he's short-term bearish on oil, and he makes the right case in this Time article here.

Boone Pickens also spent some time talking to Time magazine about oil (and his odd position in Yahoo YHOO). You can check out that video here.