Sunday, June 07, 2009

A fraud by any other name......

Some sobering analysis on the winners and losers behind USO and other ETF's.


USO Oil Fund - All of the Drops, Only Some of the Gains

Courtesy of Phil's Stock World

In fact, it’s very possible that if you did an proper investigation (perhaps a Congressional one) you would find that MOST of the oil traded on the NYMEX has nothing to do with real demand at all but is pure speculation that is sold to retail investors as "commodity investing" or "inflation hedging" but what kind of inflation hedging loses 33% a year PLUS TRANSACTION FEES before a profit can be made? Oh and a funny note - who handles USOs cash and places trades on the ICE and NYMEX for them? Aw, you guessed it - Goldman Sachs!

For the past two weeks we’ve been shorting USO on and off and it’s been very entertaining.

We all know that most ETFs are a total scam as they use a system called "creation units" to deliver shares to market WITHOUT changing the net asset value of the underlying assets of the fund. Because the funds are front-loaded (or front-unloaded) with cash during the day, professional arbitrators have a field day buying or shorting the underlying stocks or commodities that the ETFs MUST buy to "square up" their positions at the end of a day. Effectively, ETFs allow professional investors to pool the money of small investors into one, easy-to-manipulate target that follows pre-defined rules they can trade against.

In the case of USO, which has always underperformed oil by a wide margin, the divergence is so bad and the flaws in the fund are so vulnerable to attack by the already manipulative NYMEX crowd, that oil expert Stephen Schork has labeled it a pyramid scheme:

So how is this like a pyramid scheme? A pyramid scheme is funded by a constant flow of dollars into the venture by new investors. The second investor knowingly and willingly pays the first investor on the assumption he will get paid by the third investor… and so on. It’s similar to a Ponzi/Madoff scheme, with the key difference, investors don’t know (or don’t want to know as long as those alleged returns keep rolling in) they are being scammed.

The USO is being funded by a proliferation of new retail investors looking to diversify into “alternative investments” (which as far as we have been able to ascertain, alternative investment is a euphemism for Las Vegas style bets on commodities by retail investors tired of watching their 401Ks drop). More importantly, these investors are obviously out of their league, i.e. taking buy-and-hold positions in a contango which raises their cost basis every month they roll into the higher priced deferred contract.

We assume they are buying the USO because they are bullish. But in a peculiar way, their actions could be helping to prevent the market from rallying. These new investors are not funding a pyramid per se, but they are helping to fund storage. That is to say, with global demand in the doldrums, the contango will persist. And, as long as it lasts, traders will continue to front-run the rolls, which in turn will exacerbate the contango, which will then incentivize storage builds further, which will then ultimately weigh on oil prices.

As Izabella Kaminska writes in the Financial Times: "The important thing to remember is that all of the above conditions create a very unfavourable investment climate for retail investors holding USO. Oil market participants win precisely because they can play the contango trade effectively and predictably. Retail investors just lose and will continue to do so until either the contango disappears or the oil price shoots up beyond the rate of their losses. Yet many analysts agree the oil price is unlikely to ascend much higher while the contango is in place, and as Schork highlights, the contango is unlikely to disappear while the market can continue to benefit from its structure."

In other words, although USO has over 100,000 NYMEX contracts, indicating an open interest for 100M barrels of oil - they have no intention (or physical capability) of ever taking delivery of the product. The 100M barrels worth of contracts they buy and sell every month have NO VALUE to them at all, other than as a trading vehicle to generate fees. As for the suckers retail investors that put money into the fund - they would be very shocked if a truck actually pulled up to the house and delivered 100 barrels of oil to their doorstep. In effect, they ENTIRE SCHEME is based on people buying something they don’t want at all in the hopes of selling it to someone else who doesn’t want it for a higher price - this is how the whole thing collapsed so quickly the minute demand didn’t live up to expectations last fall.

The nature of this Ponzi scheme forces USO to "roll" their contracts always to the next month (to avoid delivery) and "contango" means that the front-month contracts are cheaper than the longer contracts (oil is readily available now but may not be in the future) and USO is obligated to sell their front-month barrels and exchange them for the next month, paying the spread every single month. Even in rare cases of "backwardation" (a crisis/shortage causes the front month to spike up ABOVE the longer months), USO only gets a very small advantage as they still roll just a month forward, maybe making one dollar on the way to losing the next $12.

As the next month contract BECOMES the front-month contract, the value drops again (the contango - and think if it as a CON dance and you’ve got the picture) so USO can effectively (in the above example) take your $50,000 and buy 1,000 barrels of March oil at $50, then roll them to 943 barrel of April oil at $53 (which drop to $50 again) and then roll them to 890 barrels of May oil at $53. You can run this math many different ways but there is no way you can win buying oil like this and that is how using an ETF like USO to trade will give you all of the drop of owning a commodity but only some of the gain!

Entire article: USO Oil Fund - All of the Drops, Only Some of the Gains

More links: Is the USO Oil Fund "Like a Pyramid Scheme?"
A self-propelled pyramid


Anonymous said...

FAZ seems to perform like this as well!

iv said...

Does GLD work this way as well?

btw excellent info...thanks

Ariel said...

Nice work (once again)! I've also read your Sunday EW chart analysis once, will take more time later to really absorb it but it looks good so I've recommended it (by posting the title as a link to it with attribution to you of course) to a set of my readers who appreciate chart analysis.
USO, I have been reading it as close to being done but thought it had a little work to do to finish a 5th wave around here. Just thinking, maybe you were a little early but probably not wrong. Although I personally don't have a strong opinion about what target downward - on a monthly chart I think it can reach new lows, once it puts in a reversal pattern. Just my 2 cents.