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Investing in Oil ETPs: Should You Take the Chance?

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Investing in an exchange-traded product (ETP) that invests in crude oil is not advisable for the novice investor. Because of their structure, methodology and other factors, returns can vary significantly from the actual commodity. Hence, they are a complex investment instrument that requires knowledge sufficient to understand its benefits and drawbacks–and whether such an investment is appropriate for a client.

We will examine the structure of oil ETPs, what environments are favorable and unfavorable to their performance, and examine how well they track the price of crude, using West Texas Intermediate (WTI) as our proxy for the price of crude oil. 

Understanding the Essentials

Before we get into the specific ETPs, it is important to understand some basic terminology as it relates to our subject. Rather than invest in the actual commodity, these funds purchase oil futures contracts. That’s important since the current price of crude, referred to as the spot price, will differ from the price found in a futures contract. Here’s how John Love of United States Commodity Funds explains it. The returns based on the spot price are essentially hypothetical,” Love said in an interview.  In the spot market, you’d have to “pay for storage, transportation, insurance, opportunity cost of capital, etc. This is what gets factored into futures pricing models, leading to contango, which, (give or take) theoretically reflects the storage and other costs of holding the commodity.” 

Love is implying that the expenses associated with holding and transporting crude oil are, in theory, factored into the futures price, thus creating contango, which we will explain in a moment. When you purchase a commodity futures contract, you are buying the actual commodity at a predetermined price and will take delivery when the contract expires. 

One of the most important issues relating to the performance of these ETPs is the relationship between the spot price and the price of the commodity in a futures contract. For example, if the spot price is $45, and the futures price is higher, we have a situation known as contango, which is a drag on performance.

Conversely, if the price of oil in a futures contract is lower than the spot price, backwardation is present, which as you may have guessed, is a performance tailwind. In short, the slope of the futures curve can have a dramatic effect on the performance of these ETPs. 

Criteria Used in the Analysis

Most investors are not inclined to purchase and store barrels of oil. Thus, ETPs provide a vehicle to invest in oil, even though the actual investment is in oil futures contracts. So how well do ETPs track the price of crude? To evaluate this, we must select some representative ETPs and compare their performance to the actual commodity. For this purpose, the ETP must:

1)      Attempt to track the price of WTI crude,

2)      Have a minimum of $75 million in assets

3)      Have existed during the entire period analyzed (i.e., no backfilling).

Four funds meet the criteria and are included in the table below.

 

Here are a few observations. First, three of the ETPs are limited partnerships (LP) and one is an exchange-traded note (ETN). The limited partnerships distribute a K-1 for tax purposes while the ETN provides investors with a 1099. Next, their gross expense ratios are all within a narrow range, with USL having the highest and USO the lowest. Their net expense ratio (not listed), which reflects temporary credits, might be lower. Finally, contango is a negative for each fund (we will explain why in a moment). 

The Effects of Contango and Backwardation

Some oil ETPs buy oil futures contracts on margin (using money market-type instruments) while others do not. In any event, these futures contracts expire on the 25th day of the month and each contract is equal to 1,000 barrels of crude. As mentioned, whoever holds the contract at expiration is required to take delivery of the physical commodity. Because an oil ETP never intends to take delivery of the actual commodity, it will sell its contracts prior to expiration. Some funds will use the proceeds to purchase the front-month contract (i.e., the following month) while others will spread the proceeds out over several months. This is an important point to remember as we discuss the effect of contango and backwardation. 

As a reminder, contango is present when the future price of oil is higher than the spot price and backwardation is the opposite. Thus, if the spot price of oil is $45 per barrel and the price in the futures contract is $50, contango exists. Why is this bad for performance? Since a fund never intends to take delivery of the physical commodity, it will always sell their existing contract prior to expiration. When the manager sells the contract, because the price of crude in the future is higher, the value of the existing contract will have declined relative to the spot price. Therefore, when the manager sells the contract at a lower price, he may realize a loss.

Backwardation, on the other hand, is a tailwind to performance. It is important to point out that over a period of several months, contango and backwardation may be present. 

To minimize the negative effect of contango some ETPs will spread their capital out over several months. To help explain this, we will refer to the ETPs listed in the table above, all of which adhere to a slightly different approach.

The United States Oil (Ticker: USO) ETP invests all of its capital in the front month contract. As a result, during periods of contango it will likely underperform and when backwardation is present, it should outperform.

The iPath S&P GSCI Crude Oil TR fund (Ticker: OIL) tracks the GSCI Index which follows a very similar process. There is one distinct difference, however: this fund is an ETN and as such, if the issuer (i.e., Barclays) were to become insolvent, the assets in the fund would be subject to its creditors. The PowerShares DB Oil ETP (Ticker: DBO) tracks the DBIQ Optimum Yield Crude Oil Index. If the market is in backwardation – where longer-dated contracts are less expensive at further expirations, DBO may invest as far out as 13 months.

Conversely, when the market is in contango, it may redirect its capital to shorter-dated contracts. United States 12 Month Oil (Ticker: USL) may be the most diversified ETP on the list because it sells 1/12th of its contracts each month and rolls the proceeds into the 13th month contract. Even though USL spreads its capital over a longer period to reduce the risk associated with contango, this approach may be a drag on performance when backwardation is present.

Now that we have a general understanding of the different methodologies of each fund, let us examine how well they have tracked the performance of WTI crude. 

Oil ETPs and Crude

Before we dive into the data, it is important to understand that as contango rises, the amount of performance divergence between these funds and WTI increases. The period 2009 to 2011 provides a good case study. In 2009, a year of greater contango, the price of WTI rose 78% while the performance of these ETPs ranged from 42.85% down to 11.22%. The divergence was so great that even the best-performing ETP lagged WTI by over 35%.

Contango persisted in 2010 and 2011, but it was lower than in 2009 and the divergence in returns was less. After 2011, contango declined further and the returns of these funds were more in accord with WTI. In 2013, contango and backwardation were present and one ETF (USL) slightly outperformed crude.

We have learned that these oil ETPs often do not track the price of crude for a variety of reasons. First, they invest in futures contracts rather than in the actual commodity. In addition, contango is a significant impediment toward this goal. As a result, an oil ETP may be more suitable for use as a tactical trading instrument than as a long-term hold.

The dynamics of these funds and their goal is very complex. This is precisely why investing in this type of ETP is not advisable for the novice investor.