The United States Oil Fund as a hedging instrument

This study examines the relation between spot and futures prices in the crude oil market since the inception of the commodity exchange-traded fund (ETF), the United States Oil Fund (USOF), in an attempt to identify the usefulness of the USOF as a hedging vehicle. We also investigate whether market quality in the underlying oil futures improved following the introduction of the USOF. The results show that investors who rely on the USOF returns to hedge their exposure to crude oil markets face basis risk because USOF prices deviate from crude oil futures, particularly during periods of contango. Although the USOF prices are more highly correlated with the nearby West Texas Intermediate (WTI) crude oil futures contract than they are with WTI spot prices, the futures-USOF basis is significantly greater and more volatile than the futures-spot basis over our sample period. We find that during contango, the period before July 2007, the correlation of the USOF with oil futures is lower than the correlation of spot oil prices with futures, and the futures-USOF basis is more volatile than the futures-spot basis. Multivariate analysis suggests that the change in the futures-USOF basis is greater during periods of contango, indicating that the ‘roll’ return plays an important role in the effectiveness of oil ETFs as hedges for oil prices. Our tests of market quality show that effective bid–ask spreads improve and volatility drops for oil futures following the introduction of the USOF, suggesting that the added participation of investors via oil ETFs is associated with improved liquidity in the oil futures markets.