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Silver Ready To Run Higher In Major New Upleg

Silver is ultimately driven by gold’s fortunes, so as gold continues mean reverting higher silver is going to catch a massive bid. This buying will initially come from American stock traders and futures speculators, who will aggressively buy SLV shares, cover silver-futures shorts, and add new longs. This major new buying, likely to approach a staggering couple-hundred million ounces in a matter of months, will serve to launch silver higher. Silver looks to be on the verge of a major new upleg, finally emerging from the past couple years’ ugly sentiment wasteland. This beleaguered precious metal recently bottomed as futures speculators threw in the towel on their extreme shorting. And while investors’ ongoing silver stealth buying continues, it’s been modest. So there is vast room for capital inflows to accelerate dramatically as gold mean reverts higher. Silver has always had a special allure for hardened contrarian investors. Its price action is exceptionally volatile, with massive rallies erupting from time to time that multiply capital deployed in it. With silver’s relatively-small market size, it doesn’t take a lot of new investment buying to catapult prices higher. And shifting sentiment, a powerful self-feeding motivator, fuels the big swings in capital flows that really move silver. When investors wax bullish on this white metal, its price soars with a fury few other investments can match. Later when silver falls out of favor again, prices collapse . And that’s the miserable story of the past couple years. Silver dropped 19.7% in 2014 after plunging a brutal 35.6% in 2013. Such dismal performance naturally left silver universally despised, the pariah of the investment world. But that is changing. Silver is ready to run again , a very exciting prospect given the huge uplegs it is renowned for. Silver’s fundamentals are quite unique. Though it is primarily an industrial metal with steady global supply and demand, investment capital can slosh in and out in a big way. The bullish sentiment that’s necessary to trigger big silver demand spikes comes from one thing, gold prices. Gold dominates silver psychology. When gold is weak like during recent years, investors shun silver so its price crumbles and languishes. But when gold strengthens, investors flood back into the white metal. Silver leverages and amplifies gold’s gains, making it one of the best investments when gold is returning to favor. And gold’s long-overdue mean-reversion rebound upleg out of recent years’ crazy anomalous lows is now underway . While ultimately gold drives silver through that sentiment link, the daily capital flows responsible for most of the white metal’s price action largely come through two major conduits. Stock investors add or shed silver exposure by buying or selling shares in the flagship silver ETF, the Shares Silver Trust ETF (NYSEARCA: SLV ). And silver futures are the epicenter of speculation, where traders make big leveraged bets. Both the levels of SLV’s physical-silver-bullion holdings and American speculators’ aggregate long and short contracts in silver futures reveal silver is almost certainly embarking on a major new upleg. Each of these critical capital pipelines into silver shows great room for more investor and speculator buying. And that will come as gold continues recovering on balance, unwinding its extreme anomaly of recent years. Since the pools of stock-market capital are so vast, let’s start with SLV. This ETF’s mission is to track the price of silver so stock investors can gain diversifying exposure in their portfolios. Since the supply and demand for SLV shares almost never exactly matches that of underlying silver, differential buying and selling of ETF shares develops. If not addressed, it would soon force SLV to decouple from silver and fail. In order to keep SLV share prices closely mirroring the silver price, this ETF’s custodians have to quickly equalize any excess share supply and demand into silver bullion itself. When stock investors buy SLV shares faster than silver is being bought, SLV threatens to decouple to the upside. So its custodians issue new shares, adding supply to satisfy this excess demand. The cash raised is used to buy silver bullion . Conversely, when SLV shares are being sold faster than silver, it will soon fail to the downside. The only way to prevent this is to equalize the excess SLV-share supply into silver itself. SLV’s custodians do this by buying back excess SLV shares, with these purchases funded by selling some of the silver bullion held in trust for SLV shareholders. Thus SLV holdings levels are a key barometer of silver demand. And they now reveal low stock-investor exposure to silver prices, which is very bullish since that leaves lots of room for new buying as gold continues recovering. This first chart shows SLV’s physical-silver-bullion holdings in red, with SLV prices superimposed on top in blue. As stock investors see gold and therefore silver starting to move decisively higher, they are likely to buy tens of millions of ounces in short order. Silver’s last mini-mania peaked in April 2011, above $48 per ounce. For most of the time since, silver has been grinding lower on balance. As of early November 2014 in SLV terms, silver had fallen a brutal 69.7% over 3.5 years. That powerful bear market left silver universally loathed, deeply out of favor with investors and speculators. Most assumed that vexing downward spiral would persist indefinitely. But considering how rotten and epically bearish silver sentiment has been, the trend in SLV’s holdings has been rather amazing. Since way back in May 2012, years before silver would finally bottom, the bullion that SLV holds in trust for its shareholders has risen on balance . That means stock investors were buying SLV shares faster than silver was being bought, or selling them slower than it was being sold. This contrary uptrend has witnessed dazzling episodes of strong differential buying, most notably in early 2013, mid-2013, and late 2014. Unfortunately silver prices didn’t respond super-favorably to any of these since American futures speculators were dumping vast amounts of silver contracts at the same times. But if these speculators had merely been neutral on silver, its price would have soared on SLV buying. But after SLV’s holdings hit a relatively-high 350.2m ounces as December 2014 dawned, this ETF was slammed by heavy year-end differential selling pressure. That month alone its holdings fell 5.3%, and were down 6.8% total by last week. That represents massive silver selling pressure of 23.8m ounces. And the reason for this is easy to understand. Silver had really underperformed, and institutions dominate SLV. Pension funds, mutual funds, and hedge funds are the largest SLV shareholders by far. They always want to show winners on their trading books as years end, when many investors make decisions about which funds to allocate capital to. So there is lots of so-called window dressing in December, funds buying high-performing stocks while selling laggards. With SLV down 19.5% last year, it was sure the latter. In addition, in early November silver had just slumped to a deep new 4.7-year low on extreme futures shorting. Bearishness was off-the-charts epic, with virtually everyone convinced silver was doomed to spiral lower indefinitely. So I suspect plenty of fund managers capitulated after that, saying the heck with silver. Their exit certainly contributed to the major differential selling pressure SLV suffered last month. But actually lower SLV holdings are bullish . They imply stock investors are way underexposed to silver, and leave lots of room for capital to migrate back in. With gold recovering, the odds are very high that stock investors will soon return to SLV in a serious way. The resulting differential buying pressure on SLV shares should easily blast this ETF’s holdings back up near their multi-year resistance near 352m ounces. That would require 25.6m ounces of stock-investor silver buying in short order, a big number. To put this in perspective, the venerable Silver Institute reported total global silver investment demand in 2013 of 256.0m ounces. That equates to 21.3m per month. SLV’s holdings are poised to quickly surge by at least 25m, likely in a matter of weeks. This is big marginal investment demand in such a short period of time! And that projection is far too conservative. Note above that SLV’s holdings surged up to or over their uptrend’s resistance when silver prices were quite weak . Imagine how much more intense the stock-investor silver buying through SLV will be if silver is actually surging. I fully expect that this year SLV’s holdings will easily surpass their all-time record high of 366.2m ounces achieved back in April 2011. That would require enough differential buying of SLV shares to force its holdings 39.8m ounces higher, a massive boost in investment demand. And even at that old record, the amount of capital parked in SLV would still be small. Since silver prices were so high that last time silver was really in favor, SLV’s silver bullion held in trust for its shareholders was worth $17.2b. But silver is priced far lower these days. So the same record SLV holdings levels would be worth merely $6.2b today, just over a third as much. And capital measured in single-digit billions is a trivial drop in the bucket for the stock markets. It will only take a tiny fraction of stock investors parking some diversifying capital in SLV to blast its holdings dramatically higher. And all the resulting ETF underlying physical bullion buying will accelerate silver’s upleg. In the investing world, nothing begets demand like higher prices . Investors don’t want to own anything until it is already rallying, and the longer and higher it climbs the more they buy. So uplegs in silver, and anything really, tend to be self-feeding. Buying drives prices higher, which entices in still more buyers, which lifts prices even higher, and the cycle grows. So silver investing via SLV has vast upside potential. But in recent years stock-investor capital alone has proved insufficient to ignite a major silver rally. And that is where silver’s dominant day-to-day price driver comes in, the silver futures trading by American speculators . With investors largely missing in action still after silver’s excessively-weak past couple years, futures speculators’ trading is silver’s primary driver. This critical relationship is crystal-clear in this next chart. It shows American speculators’ total long and short contracts in silver futures on a weekly basis as reported by the CFTC in its famous Commitments of Traders reports. The green line is the total long contracts speculators hold, bullish bets on silver prices. And the red line is their total shorts, the bearish bets. The yellow line shows both series’ deviation from normal years’ averages, while SLV is rendered in blue again. Silver’s extreme 4.7-year lows back in early November were solely the result of extreme selling by those American futures speculators. They effectively capitulated, convincing themselves the universal hyper-bearish outlook for silver was righteous. So they aggressively shed long contracts while spectacularly ramping shorts, subjecting silver to withering selling pressure. It’s impressive silver didn’t crater much lower. Back in July after gold surged on the Fed’s Janet Yellen claiming there was no inflation, speculators’ leveraged long-side bets on silver hit a 3.7-year high of 90.3k contracts. But as bearishness set in again thanks to heavy gold-futures shorting , their longs collapsed by 20.5% or 18.5k contracts by early December. With each contract controlling 5000 ounces of silver, that was a lot of selling for the markets to absorb. We are talking about a staggering 92.6m ounces slamming the markets in less than 5 months! It’s no wonder silver slumped to major new lows under such a massive onslaught. But it gets even worse, as the new shorting by speculators was far more extreme than their long liquidation. Between late July and early November, speculators’ total shorts skyrocketed an astounding 166.2% or 43.7k contracts! Now in the futures markets, the price impact of an existing long contract being sold or a new short one being added is identical . So speculators shorting 43.7k new contracts deluged the markets with a truly mind-boggling 218.5m ounces of silver in just over 3 months! That is the equivalent to over 5/6ths of 2013’s total global investment demand. Silver’s resiliency despite that epic selling was actually amazing. Silver’s secular bull was born back in November 2001 at just $4 an ounce, and our weekly CoT data on futures speculators’ positions extends back farther to January 1999. Speculators’ bearish bets on silver in early November of 70.0k contracts was the highest ever seen since at least then. I suspect it was an all-time record high! Speculators had likely never been more bearish, never more leveraged against silver. But since silver’s swoon was relatively mild compared to that mammoth futures selling, there had to be great latent investor demand out there absorbing that torrent of supply. The fact that investors were quietly buying when everyone was convinced silver was doomed is super-bullish. Their ranks and capital inflows will swell dramatically as gold continues mean reverting back up to far-higher normal levels. And speculator futures buying is going to fuel the early gains before investors fully take the baton in silver’s next mighty upleg. Since silver futures are so highly leveraged, selling them short is an exceedingly-risky bet. Today the CME Group only requires margin of $6500 on deposit for each silver-futures contract speculators hold. But at $17 silver, a 5000-ounce contract is worth $85,000. That’s leverage of 13.1x! Stock speculators have been legally limited to 2-to-1 leverage since 1974, 13 to 1 is crazy. Speculators who run minimum margin will lose 100% of their capital risked if silver merely moves 7.6% against their bet. And silver’s super-volatile history shows it doesn’t take long, a day or two, for such big swings to erupt. This risk is particularly acute for the speculators short silver, since they legally have to buy to cover. Shorting requires speculators to effectively borrow silver before they sell it, with the hope of buying it back later at lower prices to repay their debts. The only way to settle those debts is to close their short contracts by buying offsetting longs . This buying is compulsory as silver rallies and erodes their capital risked, so they quickly buy to cover. And as you can see, the short covering has already been fast and furious. But it’s not over yet! In the latest CoT week, speculators were still short 35.9k contracts. This remained well above their average short levels of 21.5k in the normal years between 2009 to 2012. So merely to mean revert to those norms, not even overshoot in the other direction which is always the case after extremes, they still have to buy to cover another 14.4k contracts. That equates to another 72.1m ounces of buying! Meanwhile the long-side speculators will get more bullish and bold as silver rebounds, partially on short covering. They will ramp up their bets again, inevitably pushing their total contracts back up near long-side uptrend resistance around 93k contracts. That would require 17.5k contracts of buying, or another 87.4m ounces. And don’t forget the 39.8m or so likely coming from stock traders through SLV very soon. Add speculator short covering, long contracts rebounding, and stock-investor SLV buying, and silver is looking at potential near-term buying over the coming few months of a staggering 199.3m ounces! That is the equivalent of nearly 4/5ths of the entire silver investment demand for all of 2013. The potential silver upleg that much buying in a relatively short period of time would fuel is massive. Silver is truly ready to run. And really that’s just the start. Traditional silver investing doesn’t come through silver futures or ETFs, but through physical bars and coins. And once the futures buying and ETF buying pushes silver high enough for long enough to convince investors this new upleg is the real deal, traditional physical demand will soar and take the baton. Futures and ETF buying really just jump starts the even-larger main show. With silver’s prospects out of its recent extreme lows looking so incredibly bullish, all investors need to get silver exposure in their portfolios. Physical silver bars and coins, and even SLV, are fine ways to do it. But their upside is limited to silver’s gains, they can’t leverage it. Meanwhile the best of the silver miners’ and explorers’ stocks will amplify silver’s upleg by multiples, potentially earning fortunes for investors. The bottom line is silver is ready to run higher in a major new upleg. Silver is ultimately driven by gold’s fortunes, so as gold continues mean reverting higher silver is going to catch a massive bid. This buying will initially come from American stock traders and futures speculators. They will aggressively buy SLV shares faster than silver is being bought, cover still-large silver-futures shorts, and add new silver-futures longs. This major buying, likely to approach a couple-hundred million ounces in a matter of months, will serve to launch silver higher. And nothing attracts investors like rallying prices, so global investment demand will ramp dramatically. Investors are so underexposed to silver after leaving it for dead in recent years that they will need enormous buying to attain any reasonable silver exposure. Silver will soar on these inflows. Additional disclosure: I’m long extensive gold-stock and silver-stock positions which have been recommended to our newsletter subscribers.

Arbitraging 20% As An Exuberant Closed End Fund Returns To Normalcy

Summary ETFs and CEFs that track emerging market economies are often popular with foreign investors because they mitigate some risks of owning foreign equities such as accessibility, liquidity and local governance. However, emerging economies often have substantial risks that cannot be priced out by convenience, so these funds usually trade at a discount to their NAV. Occasionally, irrational exuberance will elevate an ETF or CEF above its NAV, creating an arbitrage opportunity. The CEF CUBA has been steadily returning to normalcy after a zealous run following President Obama’s Cuban Diplomacy announcement; ~20% profit potential is still on the table. Business As Usual Exchange traded funds (ETFs) and closed end funds (CEFs) are convenient – one can buy a single asset and have a basket of exposure. ETFs and CEFs can be especially useful when they track foreign stock markets. They can mitigate a host of risk factors, such as accessibility to a foreign stock market, the liquidity of foreign equities, and local governance’s barriers to entry for foreign capital. (Sourced from Google via Barclays ) While ETFs and CEFs can neatly catalog foreign equities into a convenient bundle, risks inherent to emerging markets remain. Currency woes, inflation battles, corruption – the list isn’t a short one. Therefore, it is rather common for ETFs and CEFs to trade at a discount to their net asset value (NAV). This is a combination of risk premium as well as management and expense fees. Typically the spread between a fund’s NAV and its tick price – its discount/premium – is fairly constant. EM risk factors and management fees are generally sticky, so there isn’t much reason for the spread to fluctuate. However, an exogenous event can distort the discount, even turning it into a premium. This creates potential arbitrage opportunities. Business Is… Unusual Three and a half weeks ago, President Obama ordered a return to full diplomatic relations with Cuba. While a significant departure from the decades old stalemate, significant hurdles remain. In particular, the 54-year-old trade embargo remains. (Source: Daily Mail UK ) This highly unexpected event ignited an energetic rally in any equity with even loose ties to Cuba or the Caribbean. The Herzfeld Caribbean Basin Closed End Fund (NASDAQ: CUBA ) was one such beneficiary. At one point, it traded nearly 50% above its NAV. Now that the political reality is beginning to sink in, CUBA’s premium has seen a steady reduction. However, it is still trading well above a rational value and the spread can be approximately arbitraged out, creating a nearly risk-free investment. The Nuts And Bolts Despite its suggestive ticker, the CUBA CEF is not relegated to Cuban assets (something that would be nearly impossible); in fact, it isn’t even meant to mimic the Cuban economy in particular. To quote from the fund management’s website : The Herzfeld Caribbean Basin Fund’s investment objective is long-term capital appreciation. To achieve its objective, the Fund invests in issuers that are likely, in the Advisor’s view, to benefit from economic, political, structural and technological developments in the countries in the Caribbean Basin, which consist of Cuba, Jamaica, Trinidad and Tobago, the Bahamas, the Dominican Republic, Barbados, Aruba, Haiti, the Netherlands Antilles, the Commonwealth of Puerto Rico, Mexico, Honduras, Guatemala, Belize, Costa Rica, Panama, Colombia and Venezuela. The fund invests at least 80% of its total assets in a broad range of securities of issuers including U.S.-based companies that engage in substantial trade with, and derive substantial revenue from, operations in the Caribbean Basin Countries. Since the fund’s investment scope has a loose mandate, let’s see what some of the actual assets are: CUBA Top 25 Holdings Company Ticker CUBA Weight Country Copa Holdings CPA 8.46% United States MasTec Inc MTZ 6.28% United States Coca-Cola Femsa SAB KOF 6.03% Mexico Royal Caribbean RCL 5.34% United States Seaboard Corp SEB 5.17% United States Lennar Corp LEN 4.80% United States Norwegian Cruse Line Holdings NCLH 4.01% United States Banco Latinamericano de Comercio Exterior BLX 3.96% United States Carnival Corporation CCL 3.80% United States Consolidated Water Co CWCO 3.71% United States America Movil AMX 3.44% Mexico BanColombia CIB 3.34% Colombia Watsco Inc WSO 3.24% United States Grupo Televisa TV 2.94% Mexico Chiquita Brands International CQB 2.77% United States Freeport-McMoRan Inc FCX 2.69% United States Fomento Economico Mexicano FMX 2.67% Mexico Cemex CX 2.26% Mexico Steiner Leisure STNR 2.24% United States TECO Energy TE 2.15% United States Norfolk Southern Corp NSC 1.87% United States Wal-Mart de Mexico OTCQX:WMMVY 1.62% Mexico Tahoe Resources Inc THO 1.48% Canada Fresh Del Monte Produce Inc FDP 1.35% United States Atlantic Tele-Network Inc ATNI 1.32% United States (Source: Morningstar ) The above table represents 86.94% of the closed end fund. Fund Insiders Sell Millions Fund insiders were clearly aware of their good fortune – it’s not every day that one’s holdings start to trade nearly 50% above their intrinsic value! Consider the chart below of insider disposals charted behind CUBA’s adjusted close price: (click to enlarge) (Chart created by author; data from SEC , NASDAQ and Yahoo Finance ) The above transactions add up to nearly $4,000,000 of equity disposals. CUBA is worth around $28 million now, so the disposals were of an meaningful magnitude. In fact, with around 3,700,000 common shares outstanding, insiders sold nearly 8% of the entire float. Those transactions were the only sales by insiders in the last 12 months. The Fun Isn’t Over While the boat may have sailed on the astronomical overvaluation of a few weeks ago, there is still plenty of juice left for a mean reversion trade (or for a nearly risk-free approximate arbitrage). The CEF still trades ~11% above its NAV, and that’s cream waiting to be scraped off the top. However, it is entirely reasonable to expect the potential profit to be closer to 20%. Over the past 3 years – including the data distorting recent spike – CUBA has traded at an average discount of 8.70% to its NAV. Over the past six months – inclusive of the recent spike, again – the average discount has been 8.76%. ( Source ) (Source: CEFConnect ) It is reasonable to expect an eventual reversion to the historical discount rate yielding a potential profit of ~20%. Let’s discuss why. Plus Ca Change, Plus C’est La Meme Chose Emerging market funds, whether bundled as an ETF or a CEF, typically trade at a discount to their NAV because of risk premia and management fees. The most recently reported fiscal year saw CUBA with a reported total expense ratio of 2.46%. ( Source ) General risks to emerging market funds apply: currency risks, inflationary tendencies, payments on foreign debt, and corruption, to name a few. Many of CUBA’s holdings are readily accessible for retail investors because they trade either: directly on American exchanges, as ADRs on American exchanges, or OTC. There is no meaningful reason for CUBA to continue to trade above its NAV. The premium is totally resultant from irrational exuberance relating to President Obama’s announcement and traders buying into an investment vehicle that is (superficially) related to the geopolitical news. This is clearly evident when comparing the CEF to its NAV over a long time frame. (Source: Morningstar ) This is not to say that premiums do not occur “often” in CEFs. It is rather regular for eager bidders to push CEFs above their NAV after some unexpected bullish event has occurred. What history tells us about moments like that, though, is that the funds return to their historical trading pattern of NAV discounting because the underlying factors, mentioned earlier, motivating the spread have not changed. Exciting news doesn’t change finance fundamentals – there is no practical reason for an asset to continue to trade above its NAV for an extended period of time – it simply changes the flow of buyers and sellers, which can create a short-term dislocation between ordinary price relationships. How To Play It If one is confident in the continuation of the historical financial relationships such as the ones discussed here, then shorting CUBA is sufficient to manifest that investment view. That would be a mean reversion play and is de facto volatility selling. It makes sense for this situation, considering the recent bout of volatility was caused by an unexpected political event. If one wants to try to arbitrage the relationship, then one would have to buy an approximate basket of weighted equities that CUBA holds and short sell CUBA. Throughout the article I have been saying things like “approximate arbitrage” rather than just arbitrage – that is because there are practical limitations to achieving a pure arbitrage here. While using a mirrored basket of equities limits “risk” in a sense, it is pragmatically problematic and rather cumbersome to do so. One would have to buy ~50 positions and then weigh the individual equities according to the CEF disclosures. To do so correctly one would have to invest a decent chunk of money so as to have a common denominator between individuals positions. There is also the practical problem of information lag – most CEFs report their holdings either quarterly or semiannually. If the fund is actively managed, then one would always have an imperfect basket, regardless of the pains taken to weigh each equity properly. Of course, one could create a basket of Carribbean related assets, and weigh them according to traditional portfolio metrics (as opposed to mirroring CUBA), and assume that the correlation between those two portfolios is “good enough”. In my opinion, short CUBA is “good enough”. Historical norms will return, and CUBA will likely begin to trade at the historical discount of nearly 10% that it has traded at for years. The Opportunity In Summary What happened: Nearly all emerging market closed end funds trade at a discount to their NAV. This relationship is due to EM risk premia and management fees. CUBA is a closed end fund that is currently trading ~10% above its NAV. This premium was recently as high as 50%. The richening of the valuation was catalyzed by President Obama’s announcement of resuming diplomatic relations with Cuba. Expectations: CUBA will return to its historical average discount to NAV of ~8-10%. This leaves about ~20% of juice left in the opportunity. Reasoning CUBA, the CEF, has very indirect exposure to Cuba, the country. This is by no fault of the fund managers – it is nearly impossible (and possibly illegal) to have direct exposure to a communist country that the U.S. forbids nearly all trade with. Therefore, the run up of CUBA was likely a case of benefit-by-association. The political quagmire that is the U.S. congress is highly unlikely to normalize trade relations with Cuba – especially in an efficient manner. This reality will become evident and likely impact Cuba-related equity premiums. Risk premia and relatively high management and expense fees (~2.5% all in) justify a discount to NAV, especially when many of the top holdings in the CEF are easily accessible to U.S. investors. A long CUBA position may be a nice investment one day – basket exposure to the Carribbean is enticing, especially with the long term expectation of Cuban trade with the U.S. However, waiting for the NAV discount to return to initiate such a position is wise, and taking some easy profits while that long-standing relationship returns to normalcy is an appealing opportunity. The downside is nearly non-existent and the upside of 20% makes the opportunity worthwhile. On a closing note, consider this graphic showing emerging market closed end fund discount/premium relationships. See if you can spot the one that’s different. (click to enlarge) (Source: Wall Street Journal ) Additional disclosure: I retain the right to open L/S positions in any equities mentioned.

If You Think You Are Buying Into Oil, Think Again!

Summary Difficulty in finding a spot oil exposure in the market. USO ETF does not mirror oil price movements perfectly. Long dated oil futures might provide better exposure. There is a lot of hype now looking at oil given the large volatile swings in oil price and its overall drastic decline since about a year ago. For savvy investors, this article would probably not be very relevant because you might already know this. Retail investors who read about oil prices in the news and are very new to this should however, take a closer look. The average investor would probably think of going long or short oil via exchange traded funds, namely the United States Oil Fund or USO. Some information on USO ( website ) As of Jan. 13, 2015 Market Capitalization : 1,688 million Assets Under Management: 1,667 million Management Fee: 0.45% Total Expense Ratio: 0.76% (from 9.30.2014 fund update ) According to the USO website, USO is “designed to track the daily price movements of the West Texas Intermediate (“WTI”) light, sweet crude oil”. For retail investors, this is generally a liquid counter with an average of 16.7 million shares traded daily in the past 3 months. Notably, trading volumes seems to have picked up recently perhaps because of the coverage of oil prices in the news lately. As of Jan 13, the daily volume was 33 million shares traded. Caution is Advised If an investor wants to get exposure to Spot Oil prices without renting a vessel to physically store oil, the investor may have a wrong impression that a good way would be to buy or sell the USO ETF units. Here’s why this is quite ill advised. (click to enlarge) Plotting a chart of the USO ETF with the continuous CLc1 NYMEX prices shows a very obvious trend. In 2009, WTI prices rose from $40 to $80 in a year’s time. During the same period, USO ran up from $29 to $39. A very striking difference in the return profile for an investor who wishes to invest in spot oil prices but ends up buying something different. As prices collapsed in the middle of 2014, from about $100 to right now hitting $45, the USO declined from $37 to about $18. This is also slightly less than the CLc1 movement. For those interested in some numbers, I have extracted out the month-end closing prices of both the USO and the CLc1 in the table below. Month USO CLC1 (spot) USO +/- % CLC1 +/- % Jan-09 29.22 41.75 Feb-09 27.03 44.12 -7.49% 5.68% Mar-09 29.05 48.85 7.47% 10.72% Apr-09 28.63 50.88 -1.45% 4.16% May-09 36.41 66.95 27.17% 31.58% Jun-09 37.93 70.6 4.17% 5.45% Jul-09 36.81 69.5 -2.95% -1.56% Aug-09 36.05 69.57 -2.06% 0.10% Sep-09 36.19 70.4 0.39% 1.19% Oct-09 39.31 76.99 8.62% 9.36% Nov-09 39.16 76.42 -0.38% -0.74% Dec-09 39.28 79.62 0.31% 4.19% Jan-10 35.64 72.64 -9.27% -8.77% Feb-10 38.82 79.61 8.92% 9.60% Mar-10 40.3 83.38 3.81% 4.74% Apr-10 41.33 86.22 2.56% 3.41% May-10 34.05 74.09 -17.61% -14.07% Jun-10 33.96 75.37 -0.26% 1.73% Jul-10 35.34 78.99 4.06% 4.80% Aug-10 31.91 71.68 -9.71% -9.25% Sep-10 34.84 79.81 9.18% 11.34% Oct-10 35.14 81.92 0.86% 2.64% Nov-10 36.04 83.59 2.56% 2.04% Dec-10 39 91.4 8.21% 9.34% Jan-11 38.61 92.22 -1.00% 0.90% Feb-11 39.19 96.87 1.50% 5.04% Mar-11 42.58 106.79 8.65% 10.24% Apr-11 45.15 113.42 6.04% 6.21% May-11 40.5 102.59 -10.30% -9.55% Jun-11 37.26 95.12 -8.00% -7.28% Jul-11 37.43 95.86 0.46% 0.78% Aug-11 34.51 88.72 -7.80% -7.45% Sep-11 30.5 78.75 -11.62% -11.24% Oct-11 35.74 92.58 17.18% 17.56% Nov-11 38.78 100.5 8.51% 8.55% Dec-11 38.11 99.06 -1.73% -1.43% Jan-12 37.82 98.28 -0.76% -0.79% Feb-12 40.92 106.91 8.20% 8.78% Mar-12 39.23 102.93 -4.13% -3.72% Apr-12 39.68 104.89 1.15% 1.90% May-12 32.61 86.5 -17.82% -17.53% Jun-12 31.82 84.84 -2.42% -1.92% Jul-12 32.68 87.96 2.70% 3.68% Aug-12 35.89 96.56 9.82% 9.78% Sep-12 34.13 92.1 -4.90% -4.62% Oct-12 31.78 86.01 -6.89% -6.61% Nov-12 32.56 88.94 2.45% 3.41% Dec-12 33.36 91.79 2.46% 3.20% Jan-13 35.28 97.41 5.76% 6.12% Feb-13 33.06 91.83 -6.29% -5.73% Mar-13 34.76 97.28 5.14% 5.93% Apr-13 33.16 93.32 -4.60% -4.07% May-13 32.61 91.61 -1.66% -1.83% Jun-13 34.15 96.49 4.72% 5.33% Jul-13 37.36 105.32 9.40% 9.15% Aug-13 38.48 107.76 3.00% 2.32% Sep-13 36.85 102.29 -4.24% -5.08% Oct-13 34.69 96.24 -5.86% -5.91% Nov-13 33.46 92.78 -3.55% -3.60% Dec-13 35.32 98.7 5.56% 6.38% Jan-14 34.8 97.46 -1.47% -1.26% Feb-14 36.74 102.76 5.57% 5.44% Mar-14 36.59 101.56 -0.41% -1.17% Apr-14 36.32 99.68 -0.74% -1.85% May-14 37.68 102.93 3.74% 3.26% Jun-14 38.88 105.51 3.18% 2.51% Jul-14 36.31 97.65 -6.61% -7.45% Aug-14 35.76 95.84 -1.51% -1.85% Sep-14 34.43 91.32 -3.72% -4.72% Oct-14 30.63 80.7 -11.04% -11.63% Nov-14 25.58 65.99 -16.49% -18.23% Dec-14 20.36 53.71 -20.41% -18.61% Slight percentage variations in price movements can mean quite a lot to investors. Hence, it is better to understand why this occurs before making a decision to invest. Oil futures are currently in a contango, which basically means oil prices in the future, are worth more than the current price. This usually reflects some cost of handling and storage and cost of carry. (click to enlarge) Looking at the difference between a Dec 2015 futures price of $53.32 versus the front month futures price of $45.99, it may be easy for anyone to simplistically try to mirror a hedge strategy by trying to buy the USO and selling the Dec 2015 futures. The problem lies with how the USO is priced. Here is a snapshot of what the USO holds in its Net Asset Value disclosed: (click to enlarge) (click to enlarge) As shown above, as time progresses, the fund rolls over its holdings from the current front month futures (e.g. Feb 15 futures) into the next month (Mar 15 futures). In the process of rolling over its holdings, it sells the Feb 15 futures and buys the Mar 15 futures, hence incurring the differential cost or spread between the Feb and Mar products. In the USO prospectus page 18, this phenomenon is explained and illustrated in the example quoted below. “If the futures market is in contango, the investor would be buying a next month contract for a higher price than the current near month contract. Using again the $50 per barrel price above to represent the front month price, the price of the next month contract could be $51 per barrel, that is, 2% more expensive than the front month contract. Hypothetically, and assuming no other changes to either prevailing crude oil prices or the price relationship between the spot price, the near month contract and the next month contract (and ignoring the impact of commission costs and the income earned on cash and/or cash equivalents), the value of the next month contract would fall as it approaches expiration and becomes the new near month contract with a price of $50. In this example, it would mean that the value of an investment in the second month would tend to rise slower than the spot price of crude oil, or fall faster. As a result, it would be possible in this hypothetical example for the spot price of crude oil to have risen 10% after some period of time, while the value of the investment in the second month futures contract will have risen only 8%, assuming contango is large enough or enough time has elapsed. Similarly, the spot price of crude oil could have fallen 10% while the value of an investment in the second month futures contract could have fallen 12%. Over time, if contango remained constant, the difference would continue to increase.” Conclusion I hope I have driven the point across on the USO ETF, that it is a means to get exposure to oil price movements, but it is nowhere near a perfectly correlated product.