Monday, August 27, 2007

Whatever happened to the XLE-USO spread?

Recently Mr. Teetor, a subscriber of mine, has posted an enthusiastic comment on trading the XLE-USO spread that I suggested. While Mr. Teetor has a lot of success trading this spread, I must say that I have lost faith in the cointegrating characteristic of this spread because of two reasons:

1) The spread appeared to have experienced a regime-shift since the historic backtest period before August 2006: the out-of-sample performance of the spread since then did not support cointegration; and

2) The fundamental argument in support of cointegration between XLE and USO fell apart upon closer investigation.

The two reasons are, I believe, intertwined. Unlike GLD (part of a much more cointegrating spread that I discussed and tracked in my premium content area), USO does not actually hold commodity assets in its portfolio. It holds nearby futures contracts in oil. When the USO fund started trading in April 2006, its price per share was very close to the spot oil price. Now, however, USO is trading at about $53, while spot oil price is at about $70.6. How can a fund that is supposed to reflect oil price diverge so much from it after a year and 5 months? The reason is that the oil futures market has been in contango since 2005 or so, i.e. far month futures costs more than the nearby contracts, which results in negative roll-yield for long position in oil futures. In the historic period from which the XLE-USO cointegration relation was established, oil futures market exhibited backwardation: far month futures cost less than nearby futures. This regime shift partially explains the breakdown of the cointegration relation in the present out-of-sample period.

The lesson I have learned from all these is to avoid analyzing cointegration relation when either side of a spread involves futures contracts at different points of the forward curve, at least on a time-scale when the shape of that curve might change. (I argued before that XLE, the other side of the spread, can be modeled as an average over the entire forward curve.) Meanwhile, the fund manager of USO would really have done investors a much better favor by getting their hands dirty, leasing some oil storage tanks and buying some real oil assets rather than keeping their hands clean and dealing in futures contracts alone. After all, retail investors like myself can just as easily buy oil futures ourselves, but we can't very well go out and rent an oil tank.


Eric said...

Leasing oil storage tanks does not get you back to the futures price. You have to make a lease payment every month for the tanks, and those rates are not trivial amounts. You take on operations and maintenance expenses. You need to physically procure and transport the crude to the tanks. You are going to encounter basis differentials when you buy and sell the oil. People use futures contracts because they are a more efficient and cheaper means of hedging or taking price exposure than physically holding the commodity.

You can't expect to be long oil, either as a future or physically, with no costs associated. It would be nice if you could be magically long the spot oil price with no costs associated but there is no such instrument. Oil is a physical commodity and has costs associated with its ownership. It is fundamentally different from a bond or share of stock in this regard, you are not going to find a clever way around that other than knowledge of the market and successful active management of your exposure.

Also, you have still not recognized the most glaring flaw in your trade which I have mentioned previously. You have proposed a spread trade between an instrument with a prompt price exposure and a basket of equities with a long dated exposure. There is no theoretical or even logical reason this should be effective.

Ernie Chan said...

Dear Eric,

Thank you for pointing out this issue of operating costs. However, the goal of leasing an oil tank is not to replicate exactly the spot oil price. It is to eliminate the convenience-yield part of the roll-yield. The operating costs associated with owning oil is the same for both sides of the arbitrage trade: the oil companies forming XLE also have to pay the same operating expenses, so this cost cancels out. However, the oil companies are not holding futures contracts, they are holding the physical commodities. Therefore we need to eliminate the convenience yield, which as we saw changed sign over the course of last few years, in order for the arbitrage to work.

As for your objection to arbitraging between equities generating cash flow from selling commodity and the spot price of the commodity, I argue that the equities can be valued using an average of the forward curve. Once we agree on this, you can then empirically decide whether the average of the forward curve at any point in time cointegrates with the spot price. I believe it does. You can verify this with the other commodity pair GLD-GDX which has cointegrated very well in the out-of-sample period so far. For this pair, retail investors are fortunate that GLD actually holds gold in a vault, not gold futures contract. In the near future, I will also publish the cointegration results between silver and the silver miners as another example of the soundness of this type of arbitrage trade.


Paul Teetor said...


Thanks for commenting on my post. I appreciate your insights.

I never used USO in this spread. Rather, I only used CL futures, QM futures, and COIL futures (the ICE Brent contract). I avoided USO for the reason you mention -- but also because the leverage is so lousy for stocks.

Eric: Your point regarding time-frame is interesting. I did not trade with those time-frames in mind. Rather, I looked for a short-term divergence between the market's perception of oil prices and its perception of oil-related stocks. They usually move together. When they diverge, one can trade the mean reversion.

One final observation: You can improve the power of this trade by monitoring a relative-value measure of crude oil. I measure crude's value versus its distillate products (gasoline and heating oil) to find over- and under-pricing. For example, when crude is relatively overpriced compared to its distillates; and the XLE basket is relatively underpriced compared to crude, as indicated by the Z score, then the spread trade is especially advantageous.

Ernie Chan said...

Dear Paul,

Thank you for your additional insights. Concerning your point of using CL contracts instead of USO, I believe the effect of negative roll-yield on both is the same.


Paul Teetor said...


Yes, the CL could suffer the same problem. At the risk of talking out of both sides of my mouth, I will point out that the half-life of the spread is relatively short, so any actual trade would be short lived and not suffer much from negative roll. As a practical matter, my spread trades lasted much less than two months, for example.

I cannot speak to the effect of negative roll on your cointegration analysis. I can only speak to its effect -- or lack of effect -- on the pragmatics of the trade.

Anonymous said...

XLE-USO spread provides excellent trading opportunities. From 12/18/2006-10/09/2007, my trading model generated 10 trades: 8 win, 2 loss (80% win rate), Cumulative win return 44.69%, cumulative loss return -1.88%, net cumulative returns: 42.81%. I'm quite satisfied with this pair. Thanks.