Oil Futures, Exchange-Traded Commodities And The Oil Futures Curve

April 12, 2010

Oil Futures, Exchange-Traded Commodities And The Oil Futures Curve

Development Of Commodities Investing
Commodities markets are some of the oldest markets in the world. They have existed for thousands of years, and today’s commodities exchanges have been around for hundreds of years (the Chicago Board of Trade (CBOT) was founded in 1848 and traded its first corn contract in 1951). Despite being old markets, access to commodities for ordinary investors is still a new phenomenon. Although commodities futures have existed for many decades—agriculture futures are some of the oldest, whereas the NYMEX’s WTI oil futures started trading in 1983—commodities futures markets have been the domain of sophisticated investors. As a result, investors have previously been excluded from exposures that may benefit a portfolio’s performance.

During the last decade, commodities markets went through some fundamental changes, including (1) increased investor appetite for alternative asset classes, (2) record-low inventories coupled with tight supply, and (3) increasing demand for raw materials from emerging markets such as China and India. These factors have led to the development of a wide range of structured products on commodities. Continued demand by investors for access to simple and direct commodities exposure has more recently led to the development of exchange-traded commodities (ETCs), with Europe being the world leader in ETCs. Over the past five years, more than 140 ETCs have been listed in London, with 14 of these ETCs providing exposure to oil.

Commodities Are Priced Off Commodities Futures
One significant difference with commodities investment is that nearly all “direct” commodities investment is priced off commodities futures. This means that while commodities investing will track commodities prices, there can be slight nuances resulting in varying returns. The most common question is “Why not just price off physical spot prices?” The reason is that most physical commodities are difficult to price off because they are heterogeneous (differing in quality, weight, type, value, origin); are often hard to store and may disintegrate; and are difficult to transport, and thus illiquid. As a result, all barrels of oil or bags of coffee are not fungible (i.e., they are not all the same). Futures pricing solves all these problems. Futures contracts are standardized contracts, meaning that they are fungible. As a result, futures prices are liquid and get around the problems inherent in physical commodities. However, since commodities futures are not exactly the same as physical barrels of oil, this leads to differences in investment returns. Figure 1 shows that over the past 10 years, ETFS Brent 1 month would have outperformed the Brent “spot” oil price; however, both went through periods of relative over- and underperformance.

Oil Futures, Exchange-Traded Commodities And The Oil Futures Curve

Pricing Using Oil Futures
Figure 1 shows that an investment in oil futures can perform differently than the spot oil price (which is uninvestable). Oil futures returns are driven by three sources: (1) oil prices, (2) roll yield, and (3) interest on collateral. The roll yield is a result of the fact that oil futures expire. To prevent expiry of the oil futures (and delivery of 1,000 barrels), it is necessary to “roll” the investment. This involves selling the current oil futures contract and reinvesting the funds in a later-dated contract, thereby avoiding expiry and keeping the investor fully invested. This process of rolling can lead to either a positive effect (backwardation) or a negative effect (contango). Thus an investment in oil futures (or oil ETCs) may outperform or underperform the spot oil price at different times.

Oil Futures Contracts And The Forward Curve
An oil futures contract is a standardized contract with a specific maturity, meaning that when the contract expires, the investor of that oil futures contract will either receive 1,000 barrels of oil on a specific date in a specific location (e.g., Cushing, Okla., in the case of WTI oil futures) or the investor may receive the cash value (in the case of ICE Brent oil futures). Oil futures contracts have the widest range of delivery dates, going out more than five years. The best way to think of the oil futures curve is to compare it to the term structure of interest rates—as the maturity increases, the interest rate will vary. Similarly for oil futures, as the maturity increases, the price of that contract will vary (Figure 2). There are many theories that try to explain the shape or structure of the oil futures curve—we don’t intend to debate the theories here other than to say that no one theory is able to explain the shape of the curve at all times.

Oil Futures, Exchange-Traded Commodities And The Oil Futures Curve

Development Of ETCs And Oil ETCs
ETCs were developed a few years ago due to investor demand. Initially this investor demand was for simple access to commodities, and as a result, ETCs offering long, short, forward and leveraged exposure to more than 23 individual commodities and 11 indexes were listed on European exchanges. Since then, investor knowledge of commodities and commodities investing has come a long way; meanwhile, the liquidity of oil futures with longer maturities has grown by 500 percent to 1,000 percent over the past three to five years. Since ETCs are directly or indirectly priced off commodities futures, this provides the ability to offer ETCs with exposure to different sections of the futures curve.

ETF Securities (ETFS) created the world’s first oil ETC with Shell Trading in July 2005. Four years later, ETFS offers 14 different types of exposure to the oil market, primarily in Europe, with firms like Source, UBS and Deutsche Bank also offering similar products for European investors. In the U.S., there are several futures-based oil products to choose from, such as those offered by United States Commodity Funds. Currently, oil ETCs enable investors to take long, short, forward and leveraged positions in oil, and to choose which part of the oil futures curve they would like exposure to (from front-month out to three years), as well as choose between geographic types of oil contracts.

Comparing Oil Investment Of Different Maturities
Investing in oil ETCs or oil futures of different maturities will lead to different investment returns and properties. The differences in return are caused by the sensitivity to the spot prices and the roll yield; however, they also share some things in common, including (1) low correlation to equities and bonds, which leads to the construction of more optimal portfolios, and (2) high correlation to movements in the oil price. Figure 3 shows the optimal portfolio for equities and bonds (shown by the black line) and also a portfolio that includes an investment in different oil ETCs (shown by the colored lines). The higher curves show that an investment in oil could have improved a portfolio’s performance over the past five to 10 years.

Oil Futures, Exchange-Traded Commodities And The Oil Futures Curve

Sensitivity To Changes In The Oil Price
While all oil ETCs are correlated to the spot oil price, shorter-dated ETCs have the highest correlation to the spot oil price. This is because events that affect the current oil price will have less of an effect on the oil price in, say, three years’ time. For example, if there is a hurricane or problem at an oil refinery, this tends to be a short-term issue and will therefore affect today’s oil price, but not the oil price in three years. Factors that tend to affect longer-dated oil prices are fundamental industry changes such as tightening supplies, increased demand from emerging economies, increased riskiness of oil production and falling reserves and discovery rates.

Sensitivity To Backwardation And Contango (The “Roll Yield”)
As discussed earlier, oil futures and oil ETCs are exposed to backwardation and contango. Historically, backwardation or contango has tended to persist for two to three years at a time; therefore, depending on the current state of the market, it could be more advantageous to invest in shorter- or longer-dated oil. Based on historical simulations, an investment in shorter-dated oil (e.g., two months) outperformed an investment in longer-dated oil (e.g., three years) when the oil market was in backwardation, while longer-dated oil (e.g., three years) outperformed an investment in shorter-dated oil (e.g., two months) when the oil market was in contango.

The ability to invest in different parts of the oil futures curve also allows investors to develop trading strategies. Over the past 10 years, if an investor bought ETFS WTI 2-month when the market was in backwardation (based on a rolling three-month roll yield) and then sold this and invested the proceeds in ETFS WTI 3-year when the market was in contango, they could have outperformed a simple buy-and-hold strategy by approximately 8.5 percent per annum.

Risk And Returns
An investment in shorter-dated oil is more sensitive to the oil price and the state of the oil market. Figure 4 shows that an investment in shorter-dated oil was approximately 10 percentage points more volatile than longer-dated oil over the past 10 years. This is also supported by the fact that the maximum loss for shorter-dated oil was much greater than longer-dated oil.

Oil Futures, Exchange-Traded Commodities And The Oil Futures Curve

Therefore, with access to a platform of oil ETCs tracking oil futures along the WTI and Brent oil curves, investors are able to take full control in achieving the type of exposure they want. As Figure 5 shows, over the past 10 years the strongest-performing oil ETCs have been in longer-dated oil futures, which have also displayed generally lower volatility.

Oil Futures, Exchange-Traded Commodities And The Oil Futures Curve

Long-term buy-and-hold investors who buy on the expectation that long-term supply and demand fundamentals will push oil prices higher and who don’t want to contend with the higher volatility and higher roll yield variability of shorter-dated futures often prefer longer-dated oil ETCs such as ETFS Brent 1 year. Investors who have shorter-term time horizons and are expecting a relatively sharp near-term move in oil prices and want to get the maximum benefit from the rise often prefer oil ETCs tracking shorter-dated oil futures returns such as ETFS Brent 1 month. This strategy worked very well last year, with the shorter-term product rising 42 percent in 2009 despite the drag from contango, while the 1-year product was up 27 percent, even though contango was less of a drag. For investors who want a buy-and-hold oil ETC that tracks close to spot but is generally less affected by roll yield than front-month oil trackers, there are products that track a range of contracts of varying expirations.

Investing in commodities provides investors with additional sources of diversification that can improve portfolio performance. The development of ETCs has opened up some of the oldest markets in the world to ordinary investors. ETCs are designed to be simple, so that any investor can buy and hold an ETC in normal brokerage accounts, and unlike futures, ETCs require no daily management. ETCs are priced off underlying futures markets, and as a result, ETCs may provide exposure to different parts of the futures curve. Now investors can choose which commodity they would like to invest in, and in the case of the oil ETCs on the LSE, investors can choose exposure to either more or less volatility in spot prices and roll yields.


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