Investors continue to search for alpha in one of the most challenging environments in nearly a decade. Due in part to over two decades of massive debt accumulation, which ended in a housing bubble and deep recession, the Fed’s zero-interest-rate policy has prompted investors to search beyond stocks and bonds.
More than ever, investors are embracing alternative investments, including commodities. This had led to an expansion of commodity exchange-traded funds, where commodity investing is relatively easy. Easy perhaps, but to be successful, there are several key issues investors must understand.
What factors affect the price movements of commodity ETFs? Are commodity funds suitable to hold long term? Finally, how well do commodity funds track their benchmarks? We will address these and other questions as we take an in-depth look at ETFs that attempt to track the price of crude oil, natural gas, gold, silver, platinum and palladium.
To answer these questions, we decided to look under the hood at these commodity ETFs. To be included in this analysis, we decided the funds needed to meet certain criteria. First, the ETF must have a minimum of $100 million in assets. Second, the fund must have at least five years of history. Third, its prospectus benchmark must be a single commodity, rather than a diversified group of commodities. Six energy-related ETFs and eight precious metals funds met the criteria.
Crude Oil and Natural Gas ETFs
Before investing in the energy sector, one should become familiar with some basic terminology.
Upstream – Companies engaged in extracting the commodity (i.e., oil and gas drillers)
Midstream – Companies that transport and store the commodity (i.e., pipelines)
Downstream – Companies that refine and sell the commodity (i.e., refineries and gas stations)
Integrated – Companies engaged in both upstream and downstream activities
Spot price – The current price of the commodity
Contango – When the future price is greater than the spot price
Backwardation – When the future price is less than the spot price
The great American oil boom was largely the result of technological advances such as hydraulic fracturing, or fracking, from shale rock. The process of fracking involves injecting liquid into subterranean rock at high pressure to extract oil or gas. Because fracking is more expensive than other extraction techniques, as oil prices fell, it became less profitable.
Thus, the collapse in oil prices has led to an increase in bankruptcies, unemployed workers, loan defaults and a host of additional problems, especially in areas where the boom was strongest. From the peak of oil on June 20, 2014, through April 1, 2016, the average stock market capitalization of the U.S. energy sector has fallen 60.8%.
When investing in an oil or gas ETF, contango and backwardation are two of the most important terms to understand. Contango is a performance headwind and backwardation is a tailwind. Moreover, it is possible for both to exist during a multi-month period.
To explain, let’s assume the spot price of oil in the first month (M-1) is $50, the price in month two (M-2) is $49, and the price in month three (M-3) is $51. Thus, backwardation exists between M-1 and M-2 and contango is present between M-2 and M-3.
Contango and Backwardation
To understand the effect of contango and backwardation, we must first explain how the typical oil or natural gas ETF functions. Rather than own the physical commodity — which would require transportation and storage — these funds will purchase one or more futures contracts. When you purchase a futures contract, you are agreeing to purchase the commodity at a predetermined price and take delivery when the contract expires.
Because these funds never intend to take delivery of the actual commodity, the fund manager will sell the contract prior to expiration and roll the proceeds into new futures contracts. This is the process followed by United States Oil (USO). The ETF United States 12-Month Oil (USL) attempts to reduce the risk of contango by purchasing contracts over a 12-month period. Although this approach can be beneficial, if contango rises too high, investors will still have significant risk.
To illustrate the effect of contango and backwardation on an oil ETF, let’s look at the chart above. It contains daily data from Dec. 31, 2007, to Sept. 30, 2015. Contango and backwardation (left axis) are marked in blue and separated by a red horizontal line (contango is above the line, backwardation is below). Contango and backwardation is the difference between the price of WTI in month two (CL2) minus the current or spot price (CL1). On the right axis, the black line represents the daily price of West Texas Intermediate Crude (WTI) and the yellow line is the United States Oil fund (USO).
Notice how well USO tracked WTI in 2008. This was during a period when backwardation and contango were low. After rising in 2008, WTI ultimately fell 53.52% and USO declined 56.31%. Then, in early 2009, contango spiked dramatically. As a result, WTI and USO deviated significantly.
From Dec. 23, 2008, to June 11, 2009, the price of WTI surged 140.06%. USO only gained 32.27%. Because USL reduces the risk of contango by purchasing contracts over the ensuing 12 months, its return (36.6%) was slightly higher. Though USL was 4.33% higher than USO, it still lagged WTI by more than 103%. The divergence between oil and the oil ETFs was due to the spike in contango. As contango rises, an oil ETF’s ability to track the price of crude deteriorates.
It is also worth mentioning that during this entire period, contango was present 78.8% of the time. When is the best time to purchase this type of fund? The best conditions are when contango is low or backwardation is present and crude oil or natural gas are about to rise.
Our Oil and Natural Gas ETFs
We just discussed the mechanics of these two funds and explained some of the forces that affect their performance. Now we will examine the rest of the group to see how well they tracked their commodity.
The chart above includes the four ETFs that attempt to track the price of WTI. United States Brent Oil (BNO) is not included since its benchmark is Brent Crude. In addition, United States Natural Gas ETF is also not on the chart. The period referenced in the chart begins Dec. 6, 2007, the inception date of USL, the newest of the WTI-tracking funds. This period was unfavorable for oil prices, as the price of WTI declined 57.9%. During the same time, USL fell 67.9%, PowerShares DB Oil (DBO) lost 76.9%, USO dropped 85.9%, and iPath S&P GSCI Crude Oil (OIL) lost a staggering 90%.
BNO, the fund that attempts to track Brent Sea Crude, seemed to track its benchmark slightly better. However, contango has been relatively tame since BNO’s inception. United States Natural Gas (UNG) was launched on April 18, 2007. From UNG’s inception through March 28, 2016, the price of natural gas fell 76.4%, while UNG lost a whopping 98.4%.