Knowing how an oil fund chases price appreciation is key first step for investors.
Commodity prognosticators’ crystal balls are filled with crude oil. Brent and West Texas Intermediate oil are seen by many to be the commodities with the strongest upside potential in 2012, with possible major geopolitical events weighing heavily on the supply and demand equation.
In addition, Goldman Sachs forecast this month that Brent crude oil will reach $120 a barrel in 2012, which would represent more than a 10 percent gain from today. The firm noted that emerging market demand will remain strong through next year, pouring more demand on what many consider to be outstripped supply.
On top of forecasts like Goldman’s, Libya’s uncertain resumption of oil production and Iran’s threats to disrupt oil flow if economic sanctions are imposed could heavily impact oil price movements. Add it all up and it’s no surprise that many investors would consider a move into “black gold.”
For the average investor, buying physical crude oil is impractical. Buying barrels of oil presents a storage problem, assuming you don’t own an oil tanker, never mind liquidity issues. And when it comes to the futures and options markets, investors can become easily overwhelmed.
There are easier alternatives, though. Exchange-traded products that offer a pure oil play based on futures contracts can be a much more palatable option.
Many Different Flavors
All 14 oil ETFs and ETNs are not the same when it comes to the underlying securities. For starters, oil funds focus on one of two types of crude oil — Brent oil from European and Middle Eastern production lines, or West Texas Intermediate oil that is distributed in Cushing, Okla. And once you’ve picked your oil of choice, matching how your ETF acquires exposure with an investor’s timeline for a rise in prices is critical.
For instance, the United States Oil Fund (NYSEArca: USO), which has the most assets under management for an oil ETP, with $1.2 billion, only invests in front-month WTI contracts on NYMEX. That means it only gives investors exposure to short-term movements in oil.
The downside is that holding USO for the long term risks exposure to the effects of contango, which refers to futures contracts that become more expensive with each successive monthly contract. This undermines returns as fund managers roll into more expensive front-month contracts to maintain exposure.
There are, however, oil funds built for a longer-term holding that minimize the effects of contango.
Products like the PowerShares DB Oil Fund (NYSEArca: DBO) and the PowerShares DB Crude Oil Long ETN (NYSEArca: OLO) track benchmarks that invest in contracts with the greatest amount of backwardation, which is the opposite of contango. Backwardation occurs when spot prices exceed futures prices and each monthly contract decreases moving forward. In this case, rolling futures contracts delivers added returns.
|United States Brent Oil||BNO||76.57||1.00||57,491.70||3.54||19.54|
|Teucrium WTI Crude Oil||CRUD||5.36||1.54||1,093.23||-4.45||--|
|PowerShares DB Oil||DBO||551.62||0.75||481,717.03||2.78||2.82|
|United States Short Oil||DNO||11.64||0.96||20,161.73||-12.02||-11.98|
|PowerShares DB Crude Oil Double Short ETN||DTO||96.60||0.75||508,364.53||-25.12||-24.32|
|iPath S&P GSCI Crude Oil Total Return ETN||OIL||456.96||0.75||543,236.63||6.36||-0.66|
|iPath Pure Beta Crude Oil ETN||OLEM||5.68||0.75||1,764.17||5.76||--|
|PowerShares DB Crude Oil Long ETN||OLO||12.35||0.75||10,777.20||2.32||2.33|
|ProShares UltraShort DJ-UBS Crude Oil||SCO||109.91||0.95||1,663,928.38||-25.73||-26.00|
|PowerShares DB Crude Oil Short ETN||SZO||15.28||0.75||12,266.40||-10.70||-8.70|
|RBS Oil Trendpilot ETN||TWTI||4.20||1.10||1,114.47||--||--|
|ProShares Ultra DJ-UBS Crude Oil||UCO||277.09||0.95||1,624,316.63||3.71||-15.66|
|United States 12 Month Oil||USL||183.92||0.60||83,435.10||2.94||2.75|
|United States Oil||USO||1,123.96||0.75||11,465,515.00||5.93||-0.85|
The Brent/WTI Difference
If 2011’s action proved anything, it’s that not all crude oil is priced the same. With the price spread between Brent and WTI reaching nearly more than $25 in the past year, the two crude oils offer varying performance.
The United States Brent Oil Fund (NYSE Arca: BNO) provided the best one-year total return, at nearly 20 percent — much better than its sister product, the WTI-based USO, which saw a loss of nearly 1 percent in its one-year total return.
The sector is also gaining new players. Both the Teucrium WTI Crude Oil Fund (NYSE Arca: CRUD) and the iPath Pure Beta Crude Oil ETN (NYSE Arca: OLEM) debuted in 2011. But while CRUD is down nearly 4.45 percent in total return for the last six months, OLEM gained 5.76 percent in the same time period. Both are based on WTI futures contracts, but with clearly different methodologies.
“In the end, the ETF you choose should be based on future expectations, not past performance. Do investors think WTI will outperform Brent or vice versa?” said Paul Baiocchi, ETF analyst for IndexUniverse. “Secondly, will the contango of years past persist? You can make the right call but actually lose money should you be in a fund like USO when the market is in severe contango.”
And even with the variety of products available, better ideas could be on the way. “Blended funds offering exposure to both Brent and WTI would make a ton of sense,” Baiocchi added.
Even after determining whether to invest in crude oil, evaluating how to actually execute that call when it comes to pure oil funds requires a bigger chore. Drilling down to the underlying securities requires an understanding of how the contracts work and which crude oil they are based upon. A crystal ball can only go so far. “Being armed with so many choices is both a gift and a curse,” said Baiocchi.