Friday, July 31, 2015

Does The United States Oil ETF (USO) decay?

Since there is a lot of talk about oil lately, I thought I would do a piece on The United States Oil ETF (USO).

Recently this question was raised on StockTwits: Does USO decay?

If you have read my articles on volatility then you should be familiar with contango and backwardation. Commodity futures face the same types of futures curves, albeit more stable. Let's compare some prices charts to answer that question:

Here is the USO 1 year chart:

Here is the USO 5 year chart:

It is important to note that the spot crude price is a little behind on the first chart. 

If you take the difference between the spot price of crude and the performance of USO, it averages out to about 3% per year. The management fee in USO is 0.45% per year. 

Finally lets look at the max chart, USO began trading in April of 2006.

You don't have to be a rocket scientist to see that there is a divergence here. 

When using USO it would be best to plan this price decay into your investment objective. 

Outlook for oil

Many factors are currently at play here. China is building its reserves. U.S. drivers are driving more thanks to lower prices at the pump. Overall fuel economy continues to improve. Iran may now be able to sell their excess capacity on the open market. OPEC announced today that they don't expect production cuts.

With so much negative news, and very few positives, one might take a contrarian view here. It is my belief that someone is going to blink. We may experience more short-term pain before that happens. Ultimately capex spending will catch up to the supply side, which usually takes around six months. 

Before long we will begin to see supply level out and stability return to pricing. Oil companies can not run non-profits forever. Issuing large amounts of debts to pay dividends, not turning profits, and slashing capex spending will eventually weigh on supply. Most of the excess supply, in my opinion, is from everyone pumping to keep their heads above water. Once companies start to go under, expect consolidation. Consolidation leads to less competition, which in turn will lead to higher prices. The middle east relies on oil to fund social programs, and in the case of Saudi Arabia, massive programs. They are sitting on a pile of cash reserves. However, much of their budget is now being funded by reserves, that can't happen forever. Eventually a small pullback in production for a larger move in prices will make financial sense.  

The US Dollar is also a large part of this equation. A stronger dollar puts pressure on oil. The potential for raising of US interests rates is causing upward pressure on the dollar. An improving global economy could even out this effect. 

When will all this happen? That's the golden question. 

Just remember your holding costs when investing in any commodity fund, such as USO.

Best of luck!


  1. What about ERX? Does it decay too? What can I compare ERX against? Thank you from an avid follower.

    1. Anything with 3x leverage is going to have a lot of decay. I would look at XLE, plus with XLE you receive a dividend. Less return, but also less risk to buy and hold.

  2. Please tell people to use the promo code JUMPSTART when making a donation for the 360 Classroom. I completely missed that.

    1. I will post a twitter update. I didn't know they were matching either. Awesome of them.