With Oil ETFs, Equities Beat Futures

By now, it's not really news that oil prices are in the dumper. From investors to producers to consumers, everyone is well-aware that oil has come down quite a bit from the lofty levels of recent years.

That said, not a lot of people expect these low prices to last. There is a strong consensus among analysts that oil will rebound significantly in the coming quarters. From a current price around $45/barrel, the median forecast is for WTI crude oil to average $59 in 2016 and $65 in 2017.

All About Supply And Demand

For oil, like any commodity, pricing ultimately comes down to supply and demand. It was surging supply and slowing demand that pushed oil down during the last 15 months. If oil rebounds, it will be a reversal of those trends that sends it back up again.

While nothing is certain, the latest data does seem to suggest that analysts may turn out to be right in their call for higher prices. Both supply and demand are quickly moving in a bullish direction.

According to the International Energy Agency, demand this year may rise by 1.7 million barrels per day, the fastest pace in five years. On the supply side, the IEA expects production from non-OPEC producers to drop by 0.5 million barrels per day in 2016 on the back of tumbling U.S. drilling and output.

Playing The Rebound

In a world where oil demand is growing by more than 1.5 million barrels per day annually, supply must also grow. Ultimately, prices will need to rebound to a level that compels oil companies to invest in new wells and drill again.

What that level is, no one knows for sure. But if we use the analyst consensus as a guide, it's somewhere in the $60s. If oil rises to $65 by 2017, as analysts expect, that would equal a gain of more than 44 percent from current prices.

For investors, the question is, what is the best way to take advantage of a big jump like that in oil prices?

United States Oil Fund (USO)

Unfortunately, there’s no way to precisely capture the increase in spot oil prices. There are no physical oil exchange-traded funds available on the market, and even if there were, transaction and storage costs would significantly reduce the returns for such a fund.

The closest thing investors have to a spot oil ETF are the handful of futures-based ETFs that are out there. The most popular of these is the United States Oil Fund (USO | B-100), with nearly $2.5 billion in assets.

How It Works

An oil futures contract is an agreement to buy or sell the commodity for a given price at a specified date in the future. USO holds front-month futures contracts, which typically have a delivery date of one month or so in the future.

Spot oil prices and front-month oil futures are highly correlated, and for the most part, they’ll track each other closely. However, futures contracts have an expiration date. Anyone holding oil futures contracts on the expiration date must take physical delivery of the commodity. To avoid this, USO must roll its position over into the next-nearest futures contract before expiration.

This process of selling the front-month contract and buying the second-month contract is called "the roll." If the second-month contract is the same price as the front-month contract during the roll, USO's position size won't change, and its returns will closely mirror those of spot prices.

In reality, front- and second-month contract prices for oil are rarely the same. Due to the cost of storage, it's common for oil to be priced higher the further out along the futures curve you go, a situation called contango.

In such a scenario, USO will end up selling its front-month contracts and be able to buy less of the higher-priced second-month contracts. This is called a "roll cost," and it’s the reason the ETF has drastically underperformed spot oil prices in 2015, falling 27.9 percent versus 15.4 percent for spot oil.

YTD Returns For Spot WTI, USO, BNO, DBO, XLE

It's worth mentioning that the opposite situation from contango is possible. It's called “backwardation”; that’s when front-month futures contracts are priced above second-month futures contracts. In that case, USO will actually outperform spot oil prices. There have been periods when oil has been in backwardation, but it's been much less common to see than contango during the past decade.

United States Brent Oil (BNO)

USO is, of course, not the only option for investors wanting exposure to oil futures. Another one that takes a slightly different tack is the United States Brent Oil Fund (BNO | C-61).

Unlike USO, which holds contracts for West Texas Intermediate (WTI) crude―a grade of oil sold in the United States―BNO holds Brent, a type of oil sold in Europe.

Historically, both WTI and Brent were priced similarly, and have largely moved tick for tick. But during the past five years, the two have sometimes diverged substantially. At one point in 2011, WTI was trading at a $28 discount to Brent due to infrastructure bottlenecks in the U.S.

That discount has since narrowed to around $3, but remains volatile. BNO slightly outperformed WTI through the first nine months of 2015, with a loss of 26.7 percent.

PowerShares DB Oil (DBO)

Of course, roll costs are still a potential issue for a front-month rolling fund like BNO. Aiming to minimize the effect of contango is the PowerShares DB Oil Fund (DBO | B-88), which uses next-generation roll strategies.

Instead of mechanically rolling into the near-month oil futures contract, DBO selects the contract from the one-year futures curve that minimizes contango (or maximizes backwardation). Over time, this strategy has proven to aid returns. Since inception in 2007, DBO is down 51.2 percent compared with 69.4 percent for USO.

However, through the first nine months of 2015, the differential is less: DBO is down 27.7 percent versus down 27.9 percent for USO.

Energy Select SPDR (XLE)

Up until now, the ETFs discussed have all been tied to oil futures. These are great products for capturing short or medium-term movements in oil prices, but not for creating long-term value. USO, BNO and DBO all hit record lows earlier this year, clearly illustrating that these aren't buy-and-hold investments.

For investors with a longer-term horizon, the best way to play any oil bounce is through oil equities. There's a host of oil equity ETFs available today, but none is simpler than the Energy Select SPDR (XLE | A-92).

XLE holds a market-cap-weighted basket of stocks making up the energy sector within the S&P 500. These include companies like Exxon Mobil, Schlumberger and EOG Resources.

For long-term investors, an equity-based energy ETF like XLE is superior to the futures-based ETFs mentioned earlier, for several reasons: 1) an investor doesn't have to worry about roll costs; 2) the companies can grow their oil production, creating value for shareholders even in a flat oil price environment; 3) they often pay dividends. XLE currently has a yield of more than 3.3 percent.

Year-to-date, XLE is down by 21 percent, less than the futures-based ETFs. Over the past five years, XLE is up 20.4 percent, compared with losses ranging from 40 to 58 percent percent for the other three ETFs.

5-Year Returns For Spot WTI, USO, BNO, DBO, XLE

Contact Sumit Roy at [email protected].