How Do You Buy Spot Oil?

March 23, 2009

 

But what correlation does not tell you is the amplitude or investability of those correlations. For example, if the price of oil goes up from $10 to $20 and temperature goes from 80 to 82 degrees on a given day - that would be a perfect correlation of 1. Personally, I'd much rather make ten bucks off oil than be a little warmer.

The oil ETFs are all highly correlated with the spot price of WTI oil, which makes sense. It would be surprising to find any long asset that connected to petroleum that consistently went up on the same day oil went down. The more important question is how these investable alternatives have performed versus a hypothetical investment in in-tanker spot oil.

 

WTI Spot OIL USO USL DBO
3 mos 34.2% 37.2% 38.2% 39.4% 39.0%
6 mos 5.1% 4.7% 5.7% 6.9% 7.1%
12 mos -51.8% -68.0% -63.3% -49.7% -47.6%

 

 

Quite a wide range in returns - some performing better, some performing worse - some even doing both depending on the time frame you look at, but none exactly tracks spot's return.

 

The Futures Curve

There is a simple reason the ETFs don't exactly track the price of spot oil - they all use the futures market to trade in oil, and futures prices, by definition, are not spot oil. As a futures contract comes close to its due date, if all goes according to plan, its price can approach (or converge) on spot. But the futures price starts either higher or lower than spot, meaning that the market values future oil more or less than oil it can take delivery on today. And that difference impacts returns.

Each ETF has its own approach to deciding which contracts to hold and when those contracts must roll to the next contract. These variables open the ETFs to the effects of backwardation and contango.

The chart below was created by taking four different futures contracts and subtracting spot price from each on a daily basis. If the difference is positive (the future price is higher than spot price), the futures curve was in contango. If the difference is negative (the future price is lower than spot), the futures curve was in backwardation.

 

WTI: Futures - Spot

 

During the past two years, oil futures have switched back and forth between contango and backwardation. Logically, the front-month contracts show the least effect of both backwardation and contango - with usually only a few cents between the front-month contract and spot. But this doesn't always hold true; for example, on December 22, 2008, there was an $8.81 difference between spot and the front- month contract.

It is also interesting to note that while contango isn't new, this past fall saw some of the steepest contango we've seen in the past two years.

 

Solutions?

Ultimately, there may be no magic solution for getting the price of OIL, not OIL FUTURES, into your portfolio.

One option, which had iffy results the last time around, is the MacroShares Oil Up (and down) ETFs (UOY and DOY, for up and down, respectively). Instead of holding actual futures contracts, they hold promises-to-pay: The up fund promises to pay the down fund for any dollar change on the price of a barrel of oil, and vice versa, as measured by the front-month futures contract.

In theory, despite the fact that the word "futures" is in the description, Macros should provide something closer to the real return of the daily spot-price change in oil compared to an ETF simply rolling the front-month contract over and over again. It should also - again in theory - avoid the contango issues, since it never actually rolls anything; rather, the two funds simply exchange assets based on the daily dollar change on whatever the front-month contract happens to be.

The gigantic caveat is that there is no active arbitrage mechanism that forces the Macros to stay close to the price of oil, at least in the short term, so they often trade at large discounts or premiums to the reference price. Right now, they are trading at a 10% premium each to their reference price, so again, you can't count on them to track spot crude perfectly.

The Macros are scheduled to be liquidated on December 27, 2013. On that day, investors in the funds will be paid out based on the price of the February 2014 oil contract. That should be relatively close to the "spot" price of crude at that time, so if you wait long enough, you should get what you're looking for. In the interim, however, the returns may vary.

As investors (not necessarily traders), we need to step back once in a while and think about what we're really trying to capture. It's nice to think about the spot price of oil that we hear about on the news. But in the case of oil, the front-month contract may simply be the best economic proxy we can get.

 

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