Some of us with more of a stomach for risk are considering betting on oil’s recovery as production gets shut in and the economy gradually reopens. After all, a couple of weeks ago prices crashed and the front-month WTI futures contract went negative for the first time in history. In oil and commodities markets, the cure for low prices is low prices, and we are already starting to see some rebound.
How to play it?
Ordinarily, you would pick a futures contract to invest in directly, but most people don’t have brokerage accounts to do that. And if you’re a financial market investor, you don’t have the capacity to take delivery, so you would have to exit before the expiry of the contract. So, let’s look at some ETFs to give us this exposure. But before we do that, some understanding of how the oil futures market works will be helpful because the ETF we pick will be investing in oil futures.
Most of the time, oil futures contract prices going out 1, 3, 6 months and beyond are increasing in price because of the time value of money and storage cost of oil. Futures traders call this upward-sloping term structure contango. Occasionally, the market can get into a downward sloping term structure where the near term and spot prices are higher because of a supply disruption. This is called backwardation. You can see the upward-sloping term structure of prices here:
The reason this is important is that when an ETF owns oil futures that it must exit before they expire, it has to sell the ones it currently owns and buy new ones. When the market is in contango, this means selling contracts and buying new ones at a higher price, resulting in losses or a negative roll yield as contracts in the fund are replenished. If the market was in backwardation, the roll yield would be positive.
Let’s look at some oil ETFs:
The largest ETF, USO (NYSE:USO), uses the simple method of owning front-month contracts and gradually rolling them to the next month. This makes it highly vulnerable to the cost of the negative roll yield created by contango, and it’s significantly underperformed the WTI spot price:
This year the underperformance has been particularly dramatic with USO down 80% and the WTI front month only down 60%.
While I won’t review any of the inverse ETFs here, they generally track daily percentage changes in oil price, which mathematically leads to price decay because a 1% decline is larger than a 1% increase. So, you can’t own them for long.
What’s interesting on this list are the oil ETFs that are not down that much this year. DBO mitigates the roll yield problem by picking the contract over the next 12 months that maximizes the roll yield, so it doesn’t roll contracts as frequently and generally avoids irregularities of owning front-month contracts. It’s performed better and outperformed the oil price over time:
The USL similarly mitigates this roll-yield problem by equally diversifying among contracts going out over 12 months. However, when funds do this, price changes may be different than changes in the spot price.
The OILK avoids the K-1 reporting requirement by investing in another entity that holds the futures contracts (most funds have to be organized as a partnership to hold futures contracts), but it’s actively managed and only focuses on the front three months of contracts, which seems insufficient to blunt the roll-yield effects.
The OLEM is very thinly traded and similarly avoids the K-1 by being an ETN, but gets Barclays (LON:BARC) counter-party risk for being a note. It has tracked oil well.
Considering all the variables, if I was betting on an oil price recovery, I would pick DBO.
Carl Aschenbrenner, CFA is a portfolio manager with HCR Wealth Advisors, a registered investment advisor and wealth manager based in Los Angeles, CA.
This article represents the opinion and analysis of the author. It is offered for informational purposes only and should not be interpreted as investment advice. Neither the author nor HCR Wealth Advisors are affiliated with this website.
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