Monday, March 2, 2009

Buying the Crude ETF - The Worst Idea I Hear all the Time

Most of the people in my life know I do "something in the market." And they are always excited to either: A) ask me what gas prices are going to do, or B) tell me they want to buy a crude ETF at these levels. Since I am on pace to drive about 6000 miles (to work and back) this year I really don't care about "A". This post focuses on "B"...and maybe the most under-appreciated market dynamic in commodities - the forward price curve.

Have you noticed the steepness associated with the price curve? The current contract - April - is trading at an $8.00 discount to the December (which expires on November 30th). It is a 20% change in price in about 2/3rd's of a year. If price froze right here and only time could pass and the monthly price spreads rolled my position from month to month, I would neither make money or lose money. But at Thanksgiving time my position would be struck at almost $50/bbl. In my mind, $50 is less of a compelling buy than $38 or $40.

So one must ask before entering a position going long crude oil - "At what price will I enter and how long will I hold." If one deems the position as a long-term type opportunity, then the one clearly feels that the price will be materially higher than $50/bbl since December 1 - since $50/bbl represents the breakeven for the trade. It is kind of like going to Vegas and giving a huge vig to the don't make money until AFTER the house makes its money.

Consider shorting crude instead. Contango aids short positions, with each roll crediting the position and making the buyer short at a higher price. If you believe that the price is not destined to rally more than 20% by Thanksgiving, shorting the front month and rolling it forward is the best decision.

Note that the passive ETF that attempts to mirror crude trades the front month. So based on the logic above, a better trade than buying the ETF is selling the ETF. In that way, investors are making the contango structure of the market work for them.

Clearly, the worst idea I hear all the time is to go long crude in an ETF.

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