Over the past several months, we have been discussing various aspects of, and ways to invest in, the energy sector. Last month we examined the oil-tracking ability of four different exchange-traded products (see Investing in Oil ETPs: Should You Take the Chance?). We also learned that each fund applies a slightly different methodology, and why. Because ETPs that invest in oil are unique and complex securities, if you are not intimately familiar with the issues that influence their return, you are at a distinct disadvantage.
In this article, we will analyze one of the most critical issues an advisor must understand before investing in an oil ETP. In short, we will get up close and personal with contango and backwardation, and evaluate the effect each has on this type of security.
Last month we learned that ETPs investing in crude oil do so through oil futures. Because fund managers never intend to take physical possession of the commodity, they will always sell their contracts prior to expiration. Some managers will roll 100% of the proceeds into the following month’s contract while others spread the proceeds over several months. Why do managers differ on this point? Because investing all of the funds proceeds in the following month’s contract exposes the fund to greater contango risk.
Conversely, spreading a fund’s assets over several month’s contracts minimizes the negative effects of contango. However, there is an upside and downside with both strategies. Because backwardation is a performance tailwind, if it is present, the fund that concentrates its assets in the following month’s contract should outperform the fund that spreads its assets out.
The reason for this was discussed in last month’s article. In short, contango exists when the future price of oil is higher than the current or spot price. Backwardation is present when the future price is below the current price.
The Impact of Contango and Backwardation
To see the degree that contango and backwardation affect an oil fund’s return, we will refer to the following graph, which covers the period December 31, 2007 to September 30, 2015 and includes:
1) United States Oil Fund (ticker: USO – right axis)
2) West Texas Intermediate (WTI) Crude Oil (right axis)
3) Contango and Backwardation (left axis)
The United States Oil Fund was chosen because it is the largest Commodities Energy fund in Morningstar’s ETP database and its prospectus benchmark is WTI. Additionally, each month the fund’s manager liquidates its contracts and rolls all proceeds into the following month’s contract. Therefore, contango or backwardation is the difference between the price of oil in the following month’s contract and the current price. This is expressed as CL2-CL1.
During this period, contango was present 78.8% of the time. This is especially important since contango is a headwind to returns. Notice how contango spiked several times between late 2008 and early 2011. From mid-2011 to mid-2013, contango was relatively tame. Backwardation existed for most of 2014. Contango has been present since late last year. Now we will discuss what could be the most important point of the article: the influence of contango and backwardation.
Look at the dotted line dividing 2008 and 2009. As you can see, up to this point, the price of USO closely followed the price of WTI crude. In fact, from December 31, 2007 to November 20, 2008, the correlation between the two was 0.997. Contango and backwardation were also low during this period. However, when contango spiked in late 2008, USO and WTI began to diverge.