I am thinking of going short on USO and cover myself with 2018 oil futures contracts. Can you validate my thinking here?
(1) The 2018 Jan futures for oil is quoting at 46.60. The front month contract is quoting at 39.35. So the maximum loss I would encounter would be $7000 assuming that my investment is $46000.
(2) Now I would want to go short (for the same amount of money) on USO. As I understand, USO is representing the next months contract (currently May 2016s). When they rollover to next month, I am guessing this is happening this week, they have to loose 80 cents of rollover cost because they will be selling May contracts at 41.13 and buying June contracts at 42.06. This rollover cost is about 2%. This has to happen every month. So, USO will be getting discounted by 2% per month for the next 21 months of our investment horizon. This means that the USO will come down at the rate of (.98 exp 21) = .65. That is 1 dollar invested in USO will only be worth 65 cents. Hence my short of USO worth of 46000 to start with would give a profit of about $16000. (Intrinsically).
(3) The net profit would be $9000 (16K profit from the sort of USO and 7K losses from the oil contracts) at the end of the period (next 21 months). The APR would be 10.75%. I read that there is a fees / transaction costs reduce the value of USO by about .50%. Adding this to our returns, it would be 11.25%. This seems to be a good investment.
So, my question to you is, is there any fallacy in my hypothesis? I understand that the entire thing collapses if my assumption that there is a severe 2% rollover cost every month. Will this come down? Or will it even become negative in which case I may incur losses on both sides?
Appreciate your reply. I had not been paying huge attention during those times. Even so, can such a scenario be possible for extended periods of times?
Yes, it all depends on the thinking of real producers and real consumers rather than speculators. My current guess is that USO is doing a UNG. Unless next month is priced higher than next month +1 consistently, USO is destined to loose money.