OIL/USO and GOLD/NEM

[Buffett_Groupie]

Dear all intelligent value investors:

 

Last year when oil was at $48, http://finance.yahoo.com/quote/USO?ltr=1 was trading at $18 and now oil is at $53 and USO is only $11.75.

 

Also, when gold was at $1,300 more than 3 years ago, http://finance.yahoo.com/quote/NEM?ltr=1 was trading at $33 and now gold is $1,160 and NEM is trading at the same level.

 

How does each make logical sense?  Or how do you explain it?

 

Please enlighten me...

 

Yours truly,

 

Puzzled

[Guest]

Hey Alan,

 

I believe USO uses a lot of future contracts. These types of products are hit with contango/backwardation and that can hurt or possibly help the perspective returns. It reminds me a bit of those 3x inverse ETFs that are 3x daily but if you hold for longer terms then you can still be right but lose (or at least not as much for the risk involved. I can't say I understand I fully understand the math on these concepts but I know they can hurt you in unexpected ways.

[RichardGibbons]

The math is as follows.  Suppose oil is in contango, meaning that the near term contracts are cheaper than the long term contracts. Suppose spot oil is trading at $45, while the near term contract is at $47.  Time passes, so the price of the near term contract needs to decrease, so it falls from $47 to $45.50 with 2 weeks left until expiration.

 

But then that contract is going to disappear, so it needs to be rolled out to a later contract.  But since oil is in contango, that contract will be more expensive--say $47 again.  So then the ETF is selling the $45.50 contract and buying the $47 contract, so it's essentially lost $1.50 as a result of time decay.  If you keep on buying at $47 an selling at $45.50, you constantly lose money, causing the value of USO to decline.