Bienkowski lays out the case for why investing at different points on the oil future curve makes sense for different kinds of investors.
- The importance of futures
- Different horizons, different returns
- Deviations in standard deviation
Development of commodities investing
Commodities are some of the oldest markets in the world. Commodities have existed for thousands of years and today’s commodity 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 only a new phenomenon. Commodity futures have also existed for many decades – agriculture futures are some of the oldest, whereas the NYMEX’s WTI oil futures started trading in 1983 – however, commodity futures markets have been the domain of sophisticated investors. As a result, investors have been excluded from exposures which may benefit a portfolio’s performance.
Around 2000, commodities markets went through some fundamental changes including (i) increased investor appetite for alternative assets classes, (ii) record low inventories coupled with tight supply and (iii) 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. In the past two years, 42 ETCs have been listed in London with 8 of these ETCs providing exposure to oil.
Commodities are priced off commodity futfures
One significant difference with commodities investment is that nearly all “direct” commodities investment is priced off commodity futures. This means that while commodities investing will track commodity 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, value), often hard to store and may disintegrate, and they 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 standardised contracts meaning that they are fungible. As a result, futures prices are liquid and get around the problems inherent in physical commodities. Since commodities futures are not exactly the same as physical barrels of oil, this leads to differences in investment returns as shown in the chart below.
Pricing using oil futures
The chart above shows that an investment in oil futures was slightly different to an investment in spot oil. Oil futures returns are driven by three sources (i) oil prices, (ii) roll yield, and (iii) 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 full invested. This process of rolling can have 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 standardised 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 (eg Cushing, Oklahoma 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. There are many theories which try to explain the shape or structure of the oil futures curve – I 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.
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 on over 23 individual commodities and 11 indices were listed on European Exchanges; many products are available in the U.S. as well. Since then, investor knowledge of commodities and commodity investing has come a long way while simultaneously, the liquidity of oil futures with longer maturities has grown by 500% to 1,000% over the past three to five years. Since ETCs are directly or indirectly priced off commodity futures, this provides the ability to offer ETCs with exposure to different sections of the futures curve. As of August 2007, the London Stock Exchange (LSE) now offers a platform of eight oil ETCs offering exposure to two types of oil (WTI and Brent) with four different maturities of each.
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 (i) low correlation to equities and bonds – which leads to the construction of more optimal portfolios - and (ii) high correlation to movements in the oil price. The chart below shows the optimal portfolio for equities and bonds (shown by the black line) and also a portfolio which includes an investment in different oil ETCs (shown by the coloured lines). The higher curves show that oil improved a portfolio’s performance over the past 5-10 years.
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 which 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 which 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 or 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 (eg. 2mth) outperformed an investment in longer dated oil (eg. 3yrs) when the oil market was in backwardation, while longer dated oil (eg. 3yrs) outperformed an investment in shorter dated oil (eg. 2mth) 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 ten years, if an investor bought ETFS WTI 2mth when the market was in backwardation (based on a rolling three month roll yield) and then sold this and bought ETFS WTI 3yr when the market was in contango, they would have outperformed a buy and hold strategy by approximately 8.5% p.a.
Risk and returns
An investment in shorter dated oil is more sensitive to the oil price and also to the state of the oil market. The chart below shows that an investment in shorter dated oil was approximately twice as volatile as longer dated oil over the past ten years. This is also supported by the fact that the maximum loss for shorter dated oil was much greater than longer dated oil. While investment in different maturities shows short-term differences in the performance of oil ETCs, the average annual return was similar for all maturities over the past ten years.
Investing in commodities provides investors with additional sources of diversification which 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 new oil ETCs on the LSE, investors can choose exposure to either more or less volatility in spot prices and roll yields. In the future, more ETCs will be made available as markets develop and as investors’ knowledge of commodities increases.