Investing in Oil ETPs: Should You Take the Chance?

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 25^th 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 1/12^th of its contracts each month and rolls the proceeds into the 13^th 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.