[Seeking Alpha] Backwardation Would Be Highly Bullish For USO

One of the problems with the U.S. Oil Fund (USO) ETF I wrote about in my article on ways to trade a narrowing Brent and WTI oil spread is that it’s subject to “spoilage” in an environment where this month’s oil costs less than next month’s oil.

USO owns near-dated oil futures, so it is constantly rolling its contracts out from month to month, usually paying a premium to get next month’s contract. That’s what happens when the oil market is in contango. Funds like USO get weighed down constantly paying this premium.

But if crude oil goes into backwardation – and it’s already in a slight backwardation – a fund like USO can benefit. During backwardation, the fund actually earns a premium each month because it sells this month’s oil and then pays less than next month’s oil.

To see what I mean, let’s compare two different time periods – one from September 2010 to August 2011, when oil prices were generally rising. The other? July 2007 to June 2008, when oil prices were really rising.

Contango Vs. Backwardation

Here’s a look at the price of WTI crude from September 2010 to August 2011. The chart below it shows the contango present in the market.

And here’s a view of the July 2007 to June 2008 period. Note that during most of the period, the oil market was in backwardation with future oil costing less.

I went ahead and took a look at how a futures trader might have done during the 2010-2011 time period.

Buying one nearby contract (1000 barrels) and constantly rolling out that contract to the next month worked well at times, but constantly paying that contango premium in doing so took its toll.

The 2007-2008 period was far more successful. Actually getting paid a few dollars to roll out your contract generated higher, more consistent profits.

Comparing USO performance

< p>Now let’s look at the performance of a hypothetical $10,000 investment in USO during those time periods.

During the 2010-2011 time period, gains were modest and then largely evaporated – a lot like the futures chart above.

But back during the 2007-2008 period when the market was largely in backwardation, the fund did quite well.

This hasn’t happened very often, as the USO fund only began in 2006. But if WTI oil does move into a strong backwardation (and the market is only slightly backward now), USO would be worth considering. Until then, it’s only really suitable for short-term positions, if at all.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.