Fill er up! But what are you putting in your tank? – – The ETF with the ticker USO (for US Oil), sounded pretty attractive to many when its price plunged recently.
I mean, buy low amiright? And that’s what many people did – so much so that it was the #1 trade on Robinhood, April 21, 2020. But then, for the first time in history, prices of oil actually went negative (as did futures contract on oil, which we’ll explain at the end).
How is that possible? Isn’t that like going to the gas station, and them PAYING YOU to fill up your tank? Well, kinda…
The Big Picture
Oil is a big business and takes a lot of effort to make it to your car. It doesn’t come out of the ground ready to go, it needs to be ‘refined’. You have some companies that are drilling it up, some companies that are shipping it around, and some companies that are refining it… And this is all flowing (like the oil).
But then, when you have something like a global pandemic that shuts down many airlines (a large gas guzzler) and many other oil drinkers, then the demand for oil goes way down. And not only shutting down an oil well isn’t cheap and easy, but then turning it on and getting it flowing again at the same rate can be equally painful. So sometimes in the bigger picture, it makes sense to just keep it on. And in this case, soooo many firms decided to keep it on and flowing, that there was nowhere to store it. And when there is nowhere else to store it, THAT creates a real issue in the short term…
Future Contracts
And now back to what I mentioned at the beginning – “futures” — Simplifying a bit, the USO ETF has ‘exposure’ to oil in the US market by not actually buying OIL and sitting on it, but by buying futures. A future is a contract for something in the future.
Oil futures are what you would buy oil for in the future. So you could buy the right now oil contract (called the “spot”) or you could buy a promise for oil 1 year from now (the “future” contract). The price of Oil goes up and down based on supply/demand, and then the futures adjust to that with less certainty as you go farther out.
USO had until recently, consistently purchased the upcoming next month forward contract, and then constantly rolled that into the next month before it expired, and this way they always had ‘exposure’ to oil, but in the near term.
When the current/spot price of Oil went negative (because of the storage situation) then, the nearest month of ‘futures’ also went negative. If you go out 1 year however, the forward contracts for Oil are still positive because people think that the mismatch of supply/demand will even out in the future.
However, if it doesn’t, and the prices of oil stay negative, then USO could be rolling its investment into forwards that start off positive and then go negative as time marches on. Oooof! … And we thought Sisyphus had it bad (nerdy Greek mythology reference joke)!
The takeaways we see are 2 fold – When placing this trade, 1) we need to know a bit about the macro, bigger picture dynamics in the Oil industry, like supply and demand up/downstream companies, and 2) the vehicle used to make the trade (the ETF USO), and how it’s structured/what’s in it (futures), and some characteristics about those.
We went over a lot, but hope it was clear! For more details on all the terms here, and many other topics, head on over to our LEARN section
Read the original article HERE.