1929-1932 the Dow crash

Contango

http://thefountainhead.typepad.com/contango/2007/01/contango.html

In Hilary's own words:

When a commodity futures contract is in backwardation, an investor has two potential sources of returns. Since backwardation typically indicates scarcity, one is on the correct side of a potential price spike in the commodity by being long at that time. The other source of return involves a bit more explanation. In a backwardated futures market, a futures contract converges (or rolls up) to the spot price. This is the “roll yield” that a futures investor captures. The spot price can stay constant, but an investor will still earn returns from buying discounted futures contracts, which continuously roll up to the constant spot price. A bond investor might liken this situation to one of earning “positive carry.” In a contango market, the reverse occurs: an investor continuously locks in losses from futures contracts converging to a lower spot price. Correspondingly, a bond investor might liken this scenario to one of earning “negative carry.”

In other words, for a backwardation (contango) commodity we buy (sell) a future contract further into the delivery curve and wait for its appreciation (depreciation) as it approaches the higher (lower) spot price.

USO and contango

http://www.marketfolly.com/2009/01/how-contango-affects-crude-oil-etfs-and.html

"The US Oil Fund (Ticker: USO) holds long positions in West Texas Intermediate crude oil futures contracts, and rolls these contracts forward each month. Like most futures traders, USO buys futures with leverage, putting up a small portion of the money to buy the contracts. The rest of the money is invested in Treasuries, which generates interest income for the fund.

Three factors play a role in determining the performance of USO: 1) changes in the spot price of crude oil, 2) interest income on un-invested cash, and 3) the 'roll yield'. The first two factors are easily understood, but the third factor, 'roll yield' should be examined further in order to determine the extent, if any, to which traders of USO will be surprised by its performance in relation to spot crude oil.

First some background: Oil futures are available for each month of the year, so you can buy a futures contract right now which gives you the right to buy oil in February 2009, March 2009, April 2009, and so on. Currently, the price of oil in February 2009 is less than the price of oil in April 2009, a condition which is referred to as 'contango'. (If the opposite were true, the market for crude oil would be in backwardation.) Most commodity funds, including the US Oil Fund (USO) buy what is called the 'near month' contract and, because they do not want to take physical delivery of the commodity, they sell the current month's contract before it expires and buy into next month's contract. This process is called 'rolling forward', and it can result in the ETF paying up if the forward month contract is higher than the current month (contango), or cashing out if the opposition condition exists (backwardation).

To investigate the issue, I read through the 'risk factors' section of the USO prospectus. The following is relevant:

in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.

In essence, the USO prospectus is warning traders that USO may experience a negative 'roll yield' which may cause the NAV of USO to deviate significantly from the spot price of crude. Is there historical precedence for USO deviating from spot oil by a material amount? As it turns out, the answer is 'yes'.

During the past two years, including 2006, these markets have experienced contango. This has impacted the total return on an investment in USOF units during the past year relative to a hypothetical direct investment in crude oil. For example an investment made in USOF units on April 10 and held to December 31, 2006 decreased, based upon the changes in the closing market prices for USOF units on those days, by 23.03%, while the spot price of crude oil for immediate delivery during the same period decreased 11.18%

The conclusion, at this stage of analysis, is that USO is not a direct play on the spot price of crude oil - it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (the slop of the futures curve).

For a trader who is long USO, my instinct is that maintenance or aggravation of the contango in crude oil will cause impairment of the value of USO in relation to spot crude - whereas, any mitigation of the contango situation (including a shift to a flatter curve or backwardation) will enhance the performance of USO.

I plan to study this issue more extensively. But, in the mean time, I will not consider USO to be a good proxy for the spot price of crude oil - and I will be particularly leery of participating in USO for anything other than a short term trade."