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.
Any one of these risks would be enough to make USOF a questionable investment, but there's more...
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.
B. Patrick Regan is a freelance writer and a staff writer at StocksAndMutualFunds.com. He had no vested interest in any securities discussed in this article at the time of publication.