Oil prices have gone haywire this week. U.S. crude oil futures contracts plummeted more than 300% on Monday, crashing into negative territory. Some of those contracts would go on to explode higher on Tuesday, more than tripling in value. This unprecedented extreme volatility has speculators wanting a piece of that action.
One of the few ways they can participate in the Wild West of the crude oil market is through oil ETFs like the United States Oil Fund (NYSEMKT:USO) or the iPath Series B S&P GSCI Crude Oil Total Return Index ETN (NYSEMKT:OIL). But these trading vehicles aren't suitable for investment. Here are three reasons investors should steer clear of oil price ETFs.
1. Paper trading, not physical oil
The U.S. Oil Fund's objective is to track the daily price movements of West Texas Intermediate (WTI), which is the primary U.S. oil benchmark. It does this by purchasing oil futures contracts that expire over the next few months. While these contracts require the holder to take physical delivery of the oil upon expiration, the U.S. Oil Fund doesn't want to own physical crude. Because of that, it rolls these contracts before they expire.
That creates some frictional trading costs. Those expenses can be quite steep, especially when the oil market is in contango, which means futures contracts a few months out trade at a higher price than those expiring in the near term.
2. Expect underperformance, especially over the long term
The expenses that the U.S. Oil Fund racks up to roll its futures contracts add up over time. On top of that, it charges holders a 0.45% management fee. Those costs have weighed on the fund over the long term. That's evident in the ETF's performance relative to WTI over the years:
Since most traders buy oil price ETFs like USO for the express purpose of speculating on short-term price movements, they're likely not all that concerned about the long-term underperformance. If oil rallies sharply in the near term, the trade should make money.
But speculators often get one thing wrong: timing. While they could be correct in the view that oil will rally, that might not happen as quickly as expected. Because of that, they might need to hold their oil price ETF for several months. In doing so, they run the risk of contango and other costs eating into their returns and wiping away most of the profit (if not all of it) from an eventual rebound in crude prices.
3. Oil ETFs might not survive the recent oil rout
Interest in speculating in oil price ETFs has surged recently, given all the turmoil in the energy market. Negative oil prices aren't sustainable, suggesting that prices could spring higher. That's certainly what the futures market indicates as WTI contracts for later expirations are currently in the $30s.
However, that doesn't mean oil ETFs will survive long enough for speculators to profit from higher prices in the future. Barclays, which issues the iPath Series B S&P GSCI Crude Oil Total Return Index ETN, announced that it would stop distributing new shares on Tuesday and redeem the fund at the end of the month.
Meanwhile, trading of the U.S. Oil Fund halted twice on Tuesday due to extreme volatility. That fund also said that it would stop issuing new shares as its value whittled down to zero. This ETF might also end in a forced redemption. But even if it survives, there's such a wide gap between near-term futures contracts and those that expire in a few months that speculators might lose money (possibly their entire investment) even if oil prices rally sharply in the coming months.
Don't speculate with oil ETFs
Oil prices imploded this week because of some major near-term issues in the oil market. That's tempting optimistic speculators with the prospect of scoring a quick gain once the market sorts out its problems. As alluring as that potential upside might be, however, traders shouldn't blindly buy oil price ETFs in the hope of making a quick buck. These entities not only have a terrible track record of matching oil's movement but are also dangerously close to imploding, which could burn those who buy these products.