Investing In The Oil ETF: Go Liquid Or Pass On The Gas?

The launch of the US Oil Fund (ticker: USO) gave investors an easy way to invest in the hottest commodity of the day: oil. Still reeling from the post-Katrina boom that has kept gas prices over $2.00 a gallon, investors bought over five million shares in the ETF's first day.

The concept is an easy sell: it's a fund that invests in oil contracts with the purpose of mirroring the value of West Texas Intermediate (WTI) light, sweet crude oil at a ratio of one barrel contract per share. One share, one barrel.

Easy, right?

Riiiiiiiight...

The Well-Known Risks of Commodities

Everyone knows about the risks of investing in commodities, but it is worth repeating the main points.

Commodities prices fluctuate quickly and widely. An announcement from any OPEC country could send oil prices up or down 10% within minutes. With every word spoken by the prime minister of Iran oil pushes upward.

Oil investments are also subject to operational risks: environmental hazards such as oil spills, leaks, fires and discharges of toxic chemicals.

This is not rational long-term investing. This is short-term, profit-taking trading, and it should be treated as such.

Commodities have long been considered a hedge against market fluctuations, not a primary holding. Now they are suddenly an investment strategy. Any commodity -- oil, gold, pork bellies -- should be considered a hedge against a bond or equity market downturn.

Like gold and other commodities, oil futures have enjoyed a long bull market in the post 9-11 world, but commodities and hard assets tend toward modest gains over the long term. And they are all subject to sudden, harsh corrections.

Specific Risks of the Oil ETF (USOF)

Though any commodity investment involves certain general risks, the US OIL Fund (USOF) ETF has specific risks that make it particularly unstable.

1. Price Risk - This is the risk that the NAV of the fund will not equal the price of WTI light, sweet crude, as the fund intends. The fund's prospectus outlines three reasons why this could happen:

2. Market Risk - The trading price per share of the ETF may not correlate with the value of the NAV, which is calculated by dividing the total value of the fund's assets by the number of shares. The ETF, then, could trade at a premium (more than the underlying assets are worth) or a discount (less than the value of the underlying assets).

3. Management Risk - The NAV may not match the value of the benchmark oil contract. The underlying assets of the fund, then, could stray from the value of the contracts the fund trades.

4. Futures Arbitrage Risk - The price of the benchmark does not closely correlate with the price of WTI light, sweet crude. In this case, futures contracts may differ in price from the underlying asset (barrels).

Any one of these risks would be enough to make USOF a questionable investment, but there's more...

5. Strategy Risk - Rather than profit from speculative short-term futures trading, the USOF tries to track the price of the underlying assets (oil), using futures contracts. This is all to be carried out by the General Partner (manager), Victoria Bay Asset Management, described in the prospectus as "lean staffed," which "relies heavily on key personnel to manage trading." As the prospectus notes, "there is no assurance that the General Partner will successfully implement this investment strategy." Like stocks, futures contracts can be over- or undervalued with respect to their underlying assets. Further, the fund can be manipulated by short-term trading tactics (i.e. short selling). This fund's reliance on a "lean-staffed" manager which does not actively manage the fund's assets, but rather attempts to track an index price, does not bode well for the fund.

Legal Risks

Aside from the organizational risks, the USOF has two outstanding legal claims to contend with.

1. NYMEX - The New York Mercantile Exchange (NYMEX) is the exchange through which WTI light, sweet crude is traded. As the publisher of the price of that asset, NYMEX is challenging USOF's use of the price as a benchmark. NYMEX is seeking a licensing agreement with the fund, or threatening legal action to prevent the fund from using it as a benchmark. According to the prospectus, "USOF is unable to determine what the outcome from this matter will be...This may adversely affect USOF's ability to achieve its investment objective."

2. Goldman Sachs - One of the world's largest investment banks, Goldman Sachs, has two patents pending which may be infringed upon by the fund's methodology. Both patents define a means for creating a pooled fund that trades futures contracts and issues the equity interest of the fund to investors through publicly traded shares. Should the patents be granted, USOF may be held liable for patent infringement, if it were to "operate as currently contemplated after the patents were issued." If either of these patants is granted, the fund may be liable for royalties, which would come from the fund's assets.

These are complicated matters for attorneys in the specialized areas of Intellectual Property and Finance, and this author is unqualified to make a determination as to the merits of the claims made. As investors, however, we are all qualified to say, "nope, too much risk for me." Pure oil contracts are less risky than this fund. Should USOF be held liable for either of these claims, any damages or royalties will be taken directly from the fund's investors, which could negatively affect performance by 4-5 basis points (0.4%-0.5% annually, which can negate any positive performance or exacerbate the losses of a hedging investment).

Conflicts of Interest

The fund makes no bones about it: a whole section of its prospectus is entitled, "The General Partner Has Conflicts of Interest." The management of this fund has other investment interests that may be of more importance (to them) than this fund. "For example," it states, "a conflict may arise because the General Partner and its principal and affiliates may trade for themselves."

Essentially, this is an open invitation for the management to prioritize their own holdings (and holdings they have a vested interest in) over the USOF holdings.

Better Options Abound

Usually there are better options around, no matter what you're looking at. But when it comes to USOF, there are few worse options.

The management has not proven itself as a consistent performer. The underlying commodity is near an all-time high. The strategy is subject to pending legal decisions.

There are better options in mutual funds that specialize in commodities producers. And even these funds should not comprise more than 5% of an individual's portfolio.

If you still feel the need to invest in the "pure oil play" that's getting all the press these days, please read The Prospectus before investing.