How Do You Buy Spot Oil?

March 23, 2009

We get the emails all the time: How do I get into ‘spot' oil? The answer is, it depends.

  • The shifting definition of ‘the price of oil'
  • Separating contango from correlation
  • Real investment options


Readers often ask, "How do I buy the spot price of oil?"

The first question to ask is, which oil? West Texas Intermediate (WTI)? Brent Crude? Russian? Saudi Arabian? Oil from Dubai? The OPEC basket price?

The U.S. Energy Information Administration (EIA) does a nice job collecting the weekly average spot oil prices from countries all over the world. Maybe that's what you're looking for?

For most people, what they mean when they say "oil" is the oil they hear about on the nightly news or read about in the Wall Street Journal. If that's the case, they're not talking about spot oil at all. Instead, they're probably referring to the price of the "front-month" oil futures contract trading on the New York Mercantile Exchange. That contract covers the price of West Texas Intermediate-grade oil, delivered on a specific date within the next month to a transfer hub in Cushing, Oklahoma, and it is the de facto reference for oil prices in the U.S.

If you are reading the latest "This Week in Petroleum" from the EIA, you'll notice that they have data not only on spot prices, but prices on four different futures contracts. That's because they recognize that in the world of oil, spot and future are inextricably tied in the minds of the media.


What Is The Spot Price?

Still, the emails pour in: We want access to the spot price of oil.

What does that mean?

The spot price is what you would fork over to take physical delivery of that oil today. The EIA defines it as:


The price for a one-time open market transaction for immediate delivery of a specific quantity of product at a specific location where the commodity is purchased "on the spot" at current market rates.


The spot price is relatively unimportant in global oil markets. Most refiners purchase oil with the help of long-term contracts, either one-off privately negotiated contracts or contracts from an exchange.

But the idea of spot price is one that fascinates investors - everyone is intent on trying to invest in something that tracks "the price of oil" as closely as possible. Why? To counteract that pesky profit eater - contango.

As we cover in Hard Assets University, contango has a huge impact on investors in oil futures contracts. Contango is the situation where the "out-month" contracts are more expensive than the "near-month" contract. When that's the case, there are real costs to allowing a contract to roll forward into the next month's contract.

In fact, contango can turn rising oil prices into a loss if it is steep enough. Just a few months ago, the contango in oil was so severe that simply investing in the front month created a 15% monthly headwind. That spurred a lot of emails asking how to access spot oil, as investors in oil futures saw their investments lag further and further behind oil itself. By investing in something that tracks the spot price of oil, an investor would gain (or lose) on the movement of oil itself - not on the need to roll a contract over at the end of the month.

But how?


Investment Vehicles

As we have talked about before, there are many exchange-traded funds (ETFs) that focus solely on oil. Each ETF is structured slightly differently depending on the futures contract it holds, but all aim to give investors an easy way to invest in oil.

Because of this, as you would expect, each of the ETFs are closely correlated with spot oil prices.


Daily Correlations, 12 months ending 2/17/09

WTI 1 0.9954 0.9963 0.9941 0.9961
OIL 0.9954 1 0.9999 0.9949 0.9960
USO 0.9963 0.9999 1 0.9959 0.9970
USL 0.9941 0.9949 0.9959 1 0.9989
DBO 0.9961 0.9960 0.9970 0.9989 1



But what does a correlation tell you? A perfect correlation of 1 means that when the price of one entity goes up, the price of another also moves up. A correlation of zero means that when the price of one entity goes up, the other price moves randomly. Negative correlations mean the two are mirror images.


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