Price Moves Expose Oil ETF Differences

August 09, 2012

As oil prices creep up on hopes of economic stimulus, investors are faced with three different choices to capture returns.


Oil ETFs are back on the front burner, as investors look to capture some of crude oil’s recent gains amid hopes that central banks will step up and stimulate economies, alleviating concerns over global energy demand.

Investing in oil so far this year has been no easy task for the average investor, who was caught between an oil price plunge that cost oil futures 30 percent in a three-month period this spring, and some 15 exchange-traded products to choose from.

Now, as the market rebounds on hopes for better demand and easing concerns over global supplies—Saudi Arabia did come in and make up the production difference following an embargo imposed against Iran effective July 1—investors are again faced with tough choices among so many mousetraps.

The takeaway is that when it comes to oil funds and the return streams they generate, there’s no such thing as a one-size-fits-all strategy.

As United States Commodity Funds’ Chief Investment Officer John Hyland—the man behind the market’s largest oil ETF by assets, the United States Oil Fund (NYSEArca: USO)—puts it, when it comes to oil, there’s no right way or wrong way to go about picking an ETF—there’s only being certain about what your objective is.

Narrowing Your Focus

The choices are these: To own front-month West Texas Intermediate (WTI) oil exposure; own several months along the WTI futures curve; or own WTI’s European counterpart, Brent.

The differences between these choices so far this year would have either cost investors as much as a 8.5 percent loss year-to-date on a portfolio like USO, or netted them a gain of more than 6.5 percent through the United States Brent Oil Fund (NYSEArca: BNO). That’s hardly immaterial.

In a way, many look at USO as the catch-all proxy for the oil market because of the fund’s massive size—it boasts more than $1.4 billion in assets in a space dominated by much smaller funds—and its impressive liquidity: USO trades millions of shares on a daily basis.

But USO, like others in the space, such as the iPath S&P GSCI Crude Oil TR Index ETN (NYSEArca: OIL), is designed to reflect the spot price of WTI light, sweet crude oil, and as such, it owns primarily the front month on the WTI futures curve.

USO has lost 8.5 percent year-to-date because WTI has been in contango for several months, thanks in part to its abundant supplies.

When a market is in contango, its front month in the futures curve is also its cheapest, meaning investors have to pay up to roll into another contract upon expiration, something that eats up returns over time.

In WTI’s case, that currently means investors are paying about 27c a month to have exposure to a $93-94 barrel of WTI oil.

“WTI is in contango, but there’s still a good argument to owning a fund like USO if you are looking at holding it for a short period of time, as in days or weeks, assuming you are bullish oil,” Hyland said.

“In the short term, paying 20-25 cents in contango is not a big deal, but if you want to express a long-term view, that cost starts to add up,” he added.

It goes back to idea that a clear objective in an oil investment is everything.

Long-term oil exposure in the current market environment might be better served with a strategy that dilutes the effect of contango by diversifying allocation across various months in the WTI futures curve.

Funds like the $591 million PowerShares DB Oil ETF (NYSEArca: DBO) and the $109 million United States 12 Month Oil Fund (NYSEArca: USL) do just that. They each own several contracts along the curve to mitigate the impact of contango.

Their year-to-date performance shows the nuanced difference: DBO and USL have seen more modest year-to-date losses, about 6 to 7 percent.



Team Brent

The third alternative path to oil exposure is through Brent.

Brent oil futures are currently in backwardation, which is the opposite of contango. In backwardation, investors get paid when they roll positions upon expiration to the next contract because the nearby month is the most expensive on the curve. That enhances returns over time.

Brent futures, which are trading at about $113 a barrel, are serving up a roll yield of some $1.63, a far cry from the $3 seen in recent months, but still a sizable difference from WTI’s roll cost.

Add to that the fact that Brent futures are up roughly 5 percent on the year, significantly outperforming WTI, which is currently down by that much, and you have a solid case for a Brent ETF.

Investors have only one Brent-focused fund to choose from, the United States Brent Oil Fund (NYSEArca: BNO) designed to reflect the spot price of Brent crude oil traded on the ICE Futures Exchange.

But the fund is small—only $45 million in assets—and it doesn’t provide the liquidity some of the bigger players do. Still, on a return basis alone, BNO has shelled out a positive 6.6 percent year-to-date, while its WTI-focused counterparts have tallied losses.

The WTI-Brent Spread

That disparity in performance could be coming to a close. Tightening supplies in the U.S. Midwest could help push WTI toward narrowing the spread between it and Brent that’s now hovering $18—near its recent highs.

“In the absence of having real-time inventory figures for global crude oil supplies above ground, backwardation and contango are the next best indicators of inventory,” Hyland said, citing research conducted by Yale Professor Geert Rouwenhorst.

WTI’s contango has been dropping consistently while Brent’s backwardation has also given up ground. analyst Sumit Roy argues in his latest crude oil report that while WTI has underperformed Brent, tighter Midwest inventories could help narrow that spread to $10-15 in coming weeks.

The fundamental reason behind the spread is more than inventory related, Hyland added, noting that it’s also a reflection of a logistical problem with transportation to and from Cushing, Okla.—the place NYMEX selected as its delivery point for WTI contracts.

“Had NYMEX picked some junction in a pipeline by the Mississippi River, we wouldn’t have that problem with the spread,” Hyland said. “Cushing is landlocked, so we have a discount.”

While he doesn’t dispute that WTI’s disadvantage will be “chipped away” over time as many have suggested before, Hyland was also quick to point out that betting on a narrowing spread on the assumption that WTI would outperform Brent hasn’t necessarily paid out.

“That was a very popular bet among oil traders in late 2010 and into 2011, but they were wrong, and wrong for a long time,” he said. “It’s a workable trade, no doubt, but how long will it take for you to be right?”


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