Investors Who Buy This U.S. Oil ETF Are About to Lose a Lot of Money

April 21, 2020 7:05 PM UTC
Investors shouldn't buy an oil ETF like USO with the intention of holding it over the long-term as they could suffer huge losses.
  • U.S. oil prices crashed to record lows Monday over coronavirus-related demand constraints.
  • Retail investors who bought USO before the crash are suffering significant losses.
  • This oil ETF is only suitable for short-term trading.

Exchange-traded funds (ETFs) are very popular among retail investors. They can be a good way of getting exposure to stock and commodities markets at a low price. The problem is, a lot of individual investors don’t know what they’re doing.

We can see this by looking at the United States Oil Fund (USO)–an incredibly popular energy fund that’s one of the top 100 stocks on Robinhood. But as oil prices crashed, retail investors are getting hammered.

Investors Don’t Understand How USO Works

As oil demand drops amid coronavirus lockdowns and supply overflow, energy companies are now only looking for storage. The crisis deepened on April 20 as the May contract for U.S. WTI crude oil, which expires on Tuesday, fell below zero for the first time in history.

USO lost about 11% on April 20. Some investors might be tempted to buy this ETF now, thinking that oil prices will rebound, but they should understand the risks involved before doing so.

According to John Davi, founder and CIO of Astoria Portfolio Advisors, USO is primarily owned by retail investors. But holding it is dangerous for those who believe they are betting on rising oil prices over time without fully understanding the dynamics of the commodity market.

Davi told CNBC:

To buy USO, you have to understand the oil futures market. They [retail investors] just buy the ETF because they think the price of crude will go up, but they don’t understand the drivers, which are fairly complicated.

Many retail investors clearly don’t understand how USO works, or they wouldn’t invest in it. The U.S. oil ETF doesn’t track the WTI price, but the near-month futures contracts on WTI crude oil. That’s a big difference.

The Oil ETF Is Not For Long-Term Investors

The oil ETF is traders’ best friend, but investors’ worst enemy. Traders can make big money by profiting from USO short-term price movements. But it’s not designed for long-term investors.

USO is good at tracking near-month oil futures but terrible at following spot oil over the long term.

The ETF has underperformed the WTI crude oil spot price and has not correctly tracked its daily performance over the past five years. Investors who are bullish on long-term oil prices may want to stay away from this fund due to its underperformance.

USO is plunging sharply and trading near zero. | Source: Yahoo Finance

The reason why this ETF isn’t good at tracking oil’s spot price over the long-term is that it’s a huge pain to store crude–unlike, for example, gold or silver. It’s expensive and very dangerous. The “storage cost” is priced into the futures curve. As the contract nears expiration, USO must sell it and buy the next month out, which is usually more expensive.

The costs add up when you do this several times. That’s why USO is lagging the WTI price over the long-term.

Bjarne Schieldrop, the chief commodities analyst at SEB, said about oil ETF investors:

They are likely to burn their fingers over the coming months with a further collapse in spot prices, as well as a very negative roll-yield which will drain money out of their pockets.

Unless you’re a day trader who wants to profit from oil’s daily movements, you might want to stay away from USO.

ETFs can be an excellent investment for retail investors, but they can be dangerous if they’re not used well. Before buying an ETF, it’s essential to know what the ETF holds. If you wouldn’t be comfortable buying what an ETF holds, it probably isn’t for you.

Disclaimer: The opinions expressed in this article do not necessarily reflect the views of CCN.com and should not be considered investment advice from CCN.com. The author holds no position in USO at the time of writing.

Sam Bourgi edited this article for CCN.com. If you see a breach of our Code of Ethics or find a factual, spelling, or grammar error, please contact us.

Last modified: April 21, 2020 7:06 PM UTC

@SBChateauneuf

Stephanie has been writing about stocks and financial markets for several years. Based in Canada, she has written for The Motley Fool and Seeking Alpha. She received an MBA in finance and worked for National Bank of Canada. Check out more of her experience on LinkedIn + and follow her on Twitter. Reach her at stephanie.chateauneuf (at) gmail.com or visit her profile on Muck Rack here. Stephanie is a Trusted Journalist.