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.