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Betting On an Oil Rebound? Beware This Hidden Risk

By Dan Caplinger - Jan 17, 2015 at 6:30AM

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Some investments that purport to track the price of oil don't get the job done over the long run.

Photo credit: Flickr user Paul Lowry.

Energy prices have plunged in recent months, with the price of crude oil falling by more than half, and prices at the pump giving U.S. consumers a shot in the arm in the form of more disposable income. But amid the carnage in the energy markets, many investors believe that the price of oil has come down too far too fast, and that there's a good opportunity to profit by betting on an oil rebound.

Regardless of whether you think a rebound is in the cards or not, the one thing everyone can agree on is that if you're going to invest in the hopes of oil prices bouncing, you need to own an investment that will deliver strong returns if that happens. Unfortunately, some of the best-known investments tied to the price of oil have done a bad job of providing good returns to investors in past boom-and-bust cycles, and some signs point to the possibility that it could happen again this time even if crude prices bottom out and start to rise.

The advent of commodity-tracking funds
Almost a decade ago, the United States Oil Fund (USO -1.70%) gave investors a chance to get exposure to the crude-oil markets. Before then, you had two choices. You could invest in energy companies, which would give you indirect exposure to oil-price changes but leave you vulnerable to company-specific operational risks; or you could invest directly in oil-futures contracts. The fund, however, opened the door to rank-and-file investors to speculate on oil prices, and it became increasingly popular during 2007 and 2008, when the oil boom carried prices almost to the $150-per-barrel mark, and gave investors in the fund strong returns.

Source: Flickr/Lindsey G.

When the ensuing commodity bust occurred in late 2008, oil prices tanked, and as you'd expect, the United States Oil Fund fell along with them, losing about three-quarters of its value as crude prices eventually bottomed out around $35 per barrel. But then a strange thing happened. Many investors believed that oil prices would recover from those levels, and indeed, by mid-2009, oil traded around $70 per barrel. But even though oil prices had doubled, the United States Oil Fund didn't rise by the same amount, with gains of just 20% between mid-December 2008 and mid-June 2009.

What you must know about commodity trackers
The difficulty that United States Oil Fund and some other commodity funds have to deal with is that it's not possible to track spot prices perfectly using futures contracts. To avoid taking delivery of physical crude oil, the fund has to roll over contracts according to a precise schedule each month.

That isn't automatically bad, but the oil-futures market often has later-month futures that are more expensive than near-month futures. In other words, when you roll over your contracts each month, you have to accept a slightly higher price -- and that erodes your eventual gains. That phenomenon is also known as contango, and it can have a huge downward impact on returns for futures-based investment strategies.

Image source: Flickr/Roy Luck.

Right now, the oil market is in the same state of contango as it was during much of 2009. Looking right now at oil-futures quotes, the market already expects oil prices to rise by 1% to 1.5% per month throughout 2015. Futures for January 2016 trade above $55 per barrel, compared to just $48.50 for the current contract. As a result, if those conditions persist, the price of oil could rise more than 13% in a year; yet a fund that tracks oil futures and rolls contracts over every month would see no positive return at all.

There's no such thing as a free lunch
In order to get direct exposure to crude-oil prices, you'd have to buy the crude itself. That would saddle you with all the expenses of shipping, storing, and eventually delivering the oil for later sale. Using futures contracts saves you all that hassle and expenses -- but that convenience doesn't come free, and that's why United States Oil Fund doesn't give you the same returns as spot crude.

That doesn't mean that using the fund is a mistake. Yet, if you don't want a nasty surprise, you simply need to understand that you can't expect oil-tracking investments using futures strategies to give you the same gains as spot oil even if a rebound does occur.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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