How Oil ETFs Work

May 19, 2020

By this point, you may already know that oil ETFs don't track the physical spot price of oil; they track crude oil futures contracts instead.

However, those futures contracts don't last forever. They expire, closing for new investment—meaning that the ETFs holding them must replace their portfolios regularly.

That process isn't necessarily obvious, especially for beginner investors. Below we answer a few of the most commonly asked questions, and hopefully clear up some of the confusion.

What Does It Mean To ‘Roll’ Contracts?

Today the current month's crude oil futures contract is slated to expire. In practical terms, that means that anybody left holding the June 2020 contract at the close of markets is assumed to be either giving or taking physical delivery of 1,000 barrels of oil, per contract, at the closing expiration price.

Physical delivery is the whole point of futures contracts, of course; these instruments allow oil producers and consumers a standardized means by which they can negotiate the terms and flow of future supply.

But investors—or ETFs—holding crude oil futures as a proxy for spot prices don't necessarily have the desire or ability to store hundreds of drum barrels in one go. Therefore, parties wanting to maintain a constant position must "roll" their contracts—meaning they must sell the expiring contract and purchase the next nearest month's instead.

The roll process is fundamental to the life cycle of an oil ETF, and its cost matters more than you might at first assume. While most of the conversation hyperfocuses on oil prices—are they up? are they down?—in practice, its yield from this roll process is where the real money is made or lost.

Why Does Roll Matter So Much?

Any ETF that tracks commodity futures will be continually updating that position as the current month's contracts expire. That means regular buying and selling of contracts.

If contracts with later expiration dates (i.e., those farther out on the futures curve) are more expensive than nearer-term ones, then the commodity is said to be in contango. As an example, here's what the crude oil futures curve looks like right now:


Source: Bloomberg. Data as of May 19, 2010

If the reverse is true, then the commodity is in backwardation. (Read: A Guide To Contango & Backwardation.) Backwardation in oil might look something like this (note: this is just a hypothetical for illustrative purposes):

For ETFs in particular, contango can be a killer. As long as contango lasts, replacing contracts with more expensive contracts will mean the ETF must buy high and sell low, thus steadily eroding investors' returns.

For example, say there's an ETF that holds front-month WTI crude oil contracts, each worth $30/barrel, while the next month's contract is being sold for $31. When it's time to roll contracts, the ETF will be able to buy 3% fewer crude oil contracts with the same amount of money, due to the higher price.

Over the course of a year, that 3% monthly cost adds up to nearly 40%, which could easily wipe out any gains that the spot price made—or, more likely in this environment, exacerbate any losses.

Of course, in backwardation, the opposite is true; the ETF makes money on the roll into cheaper contracts. But oil is in contango right now—such a steep contango, in fact, that some analysts are calling it "super contango." And there's no end in sight.

Could My Oil ETF's Price Go Negative?

Maybe. Nobody really knows the answer for certain, because it's never happened before. However, the chances of an oil ETF's price going negative are very, very slight.

That's because most ETFs, even those that hold only front-month futures contracts, build in some buffer period before each roll period.

For example, the United States Oil Fund LP (USO) still has language in its prospectus indicating it will roll any front-month contracts two weeks before expiration, as does the other major oil fund from U.S. Commodity Funds, the United States 12 Month Oil Fund LP (USL), which holds a basket including each of the next 12 months' worth of contracts. USCF also publishes roll dates on the websites for individual funds.

Meanwhile, the ProShares Ultra Bloomberg Crude Oil (UCO) and the ProShares UltraShort Bloomberg Crude Oil (SCO) roll their contracts over a five-day period starting on the sixth business day of the month and ending on the tenth.

For context, futures contracts expire on the third Tuesday of the month—meaning UCO and SCO still have ample time to get out of the contract before it expires.

The specific timing of roll dates and how long the roll period lasts differ from fund to fund. As always, read the prospectus of any fund you're interested in carefully before investing in it.

But Didn't USO Cause Oil Prices To Go Negative?

Not at all. In fact, when the May 2020 crude oil contract went negative on April 20, hitting -$37.63/barrel, USO had already long since completed its roll period. By that point, it hadn't held any May 2020 contracts for at least two weeks.

Since then, USO has shifted from a front month-only strategy to an actively managed blend of oil futures contracts that can be changed around at any time. (Read: "More Changes For Biggest Oil ETF")

But rather than exposing investors to greater risk, the change was implemented in part to further safeguard USO from the possibility of holding contracts that could go negative, by giving the fund managers greater discretion to purchase contracts across the curve.

But What About Oil ETNs?

Oil ETNs (exchange-traded notes) are an interesting case, because they track oil futures prices without actually holding the contracts themselves.

ETNs are debt obligations that can be tied to an index of oil futures, such that the return of that benchmark serves as the note's return. But the notes themselves don't actually hold a portfolio of securities that can be bought or sold.

In the case of oil futures, that can be a good thing, as it shields ETNs from the effects of contango. Without the actual sale and purchase of any real contracts, the impact of roll yield on an ETN's returns becomes minimal.

Of course, all this is mostly moot, as the vast majority of oil ETNs closed in March of this year. (Read: "Leveraged ETF Closures Piling Up.")

Contact Lara Crigger at [email protected]

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