The Boons and Banes of Oil ETNs 19 comments
Hard Assets Investor
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Way back in the Pleistocene Era (okay ... it was really just nine months ago), we asked why there weren't more inverse funds on offer for commodity investors ("Where Are The Short Funds?"). Our beef back then specifically focused on oil. Without short oil and distillate exposure available in exchange-traded funds or notes, we groused, there's no securities side alternative for futures crack spreads (examples of which are illustrated in "Energy Spreads Offer Leveraged Profits, Reduced Risk").
Well, the industry's put out some inverse products since then. Not a whole lot, mind you, but some. There are a lot more inverse products in registration, along with more leveraged commodity exposures.
So, are we happy now? Well, to the degree that there are more choices available for investors, yes. But we should point out that, performancewise, the newly introduced short notes and funds are not mirror images of their long counterparts. That is, you won't get the same results from buying an inverse product as you would by selling short its opposite number. The returns can sometimes be boons and sometimes banes, depending upon the shape of the futures price curve.
Oil-tracking exchange-traded products are prime examples. The returns obtained from purchasing inverse oil products have been largely influenced by recent shifts in the crude oil price structure from contango to backwardation and back.
Contango refers to the premium commanded by deferred futures over nearby contracts, as illustrated in "It's The Oil Carry, Not The Contango." When, for instance, March crude trades for $41 and April at $46, there's said to be a $5 contango. Contango markets are unloved by holders of long index funds and notes because of the negative yield – negative $5 in this case – that must be absorbed when a roll from an expiring nearby contract to a forward month is dictated. To roll a long position forward, March would have to be sold for $41 and April bought at $46.
Holders of inverse or short products, however, think a contango is swell. For good reason. To roll a short position forward, the nearby contract is purchased – to cover the existing short – and the forward contract sold to establish a new short position, the opposite of the swap done by long index investors. That yields a $5 gain or positive yield in this instance.
Last summer, a suite of inverse and leveraged oil notes were issued by Deutsche Bank just in time to catch the steep sell-off in crude prices. Each note tracks an oil subset of the Deutsche Bank Liquid Commodity Index (DBLCI). All are based upon the Optimum Yield version of DBLCI, which attempts to optimize roll returns by "shopping" for the most advantageous swap. Joining the PowerShares DB Crude Oil Long ETN (NYSE Arca: OLO) in the rollout were the PowerShares DB Crude Oil Short ETN (NYSE Arca: SZO), the PowerShares DB Crude Oil Double Long ETN (NYSE Arca: DXO) and the PowerShares DB Crude Oil Double Short ETN (NYSE Arca: DTO).
A plot of the inverse notes' performance against short sales of their complementary stablemates reveals the real-world effect of the oil market's contango. By comparing the return obtained from purchasing the short oil note, SZO, to that realized from a short sale of OLO, we can visualize the benefit provided by contango to bearish investors. Likewise, a long position in the double-short DTO note can be gauged against a DXO short sale.
In the early stages of the crude oil sell-off, the short sale positions actually held a performance advantage due to a contraction in the oil market's contango. The quarterly contango reached a peak at $1.84 per barrel in July, but started to shrink as summer wound down. There were, in fact, even a few days of backwardation in the early fall, but by mid-October the oil contango started to inflate again, finally reaching a peak, to date, of $15.21 per barrel.
The freshening contango was wind to the back of the inverse notes, propelling their values above that of the equity in their short-sold counterparts.
DB Oil Index ETN Performance
By early February, crude oil had fallen 70%, precipitating a 198% gain in SZO, and a 129% profit from a short OLO position. Most dramatically, DTO's earned a whopping 647% increase. Shorting DXO realized a 181% gain. In the end, the inverse notes were able to draft in contango's wake to post outsized profits.
All this is an interesting bit of history (well, to a wonk like me, anyway), but what value does this have for investors now? Just this: The oil market has been attempting to build a bottom recently; eventually, oil prices will rise. That will present investors with two new scenarios – rising prices and backwardation.
To better exploit your profit-making or hedging potential in that environment, you'll have to pick your investment tools carefully. Knowing a little something of the DB notes' reactions to price action and the futures term structure will go a long way toward helping you take the right approach.
You can find a snapshot of the DB oil notes in "ETN Oil Liquidity."
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So I decided to buy some shares of DXO at $2.40 and wait it out ..when oil start to raise then I should make some nice profits on DXO. I think DXO can easily hit $10-$15 level by next year (if oil hits $60-$80 level) and then I will probably sell ..I just need to be patient. All I can lose is my original investment in DXO. Perhaps I will be right or perhaps I will be wrong only time will answer that question.
On Feb 16 07:16 PM Dark Night wrote:
> Yes, oil prices has fallen dramatically but if u think that these
> oil prices will stay low for the long term then that will be a fanasty.
> Oil companies & OPEC has cut back capacity and exploriation and
> sooner or later the oil oversupply will correct. Henry Groppe , a
> noted oil analyst predicted that oil will fall below the $40 mark
> by 2009 because of oil speculation and now he and his investment
> group is predictating that oil will swing back to the $60-80 level
> by the end of next year. His track record has been very good. <br/>
>
> So I decided to buy some shares of DXO at $2.40 and wait it out ..when
> oil start to raise then I should make some nice profits on DXO. I
> think DXO can easily hit $10-$15 level by next year (if oil hits
> $60-$80 level) and then I will probably sell ..I just need to be
> patient. All I can lose is my original investment in DXO. Perhaps
> I will be right or perhaps I will be wrong only time will answer
> that question.
With labor and other costs going up, that's a reasonable figure.
"Dark Night" is right, agree 100%. DXO is a good pick.
For oil refiners, this quarter's downstream pricing has been providing a nice, fat margin (if they're not locked into hedge contracts). They're MORE than breaking even.
On Feb 17 03:02 AM PeteK wrote:
> Most oil company CEO agree that oil has to be around $50 to break
> even.
> With labor and other costs going up, that's a reasonable figure.
>
> "Dark Night" is right, agree 100%. DXO is a good pick.
>
>oil start to raise then I should make some nice profits on DXO. I think
>DXO can easily hit $10-$15 level by next year (if oil hits $60-$80 level)
DXO is 1.8 now. For it to hit $10 it would have to go up around 500%, which means oil would go up about 250%. Oil is at $35 now. That's oil above $100. In your dreams.
DXO suffers not just from contango but from being leveraged as well. They get you on the front, and then they rip on you on the back.
Stay away from DXO.
Oil will not go above $50 for another two years because of fallen demand. OPEC will cut, but that will be just enough to prevent a total price collapse to $10. Think $20s.
Short of some sort of war in the middle east. But Obama is not Bush.
stop buying on the way down!!! wait for strength and buy when it goes up!
do you buy houses when they're dropping or when their value is rising!
please stop doing what you're doing -- DO THE OPPOSITE!
Cash is the only thing going up now outside of selective shorting. Cash is going up because alot else is going down.
On Feb 21 05:44 AM GOEBOC wrote:
> Then, what is the conclusion in a backwardation situation, is it
> that you must buy the double long etn instead of shorting the double
> short? That is it?
When the market slips into contango, that's a hint of adequate or, in fact, over supply. After all, for a carrying charge market to exist, there must be supply to carry. Contango markets, all else held constant, favors short positions since futures should converge to the cash price at expiry.
The way you play the short/long game (i.e., buying one fund verse shorting its opposite) depends upon your ability or inclination to use margin and your expectations about the shape of the futures term structure.
It wasn't just a contango that propelled the DTO double-short note to such outsized gains; it was a WIDENING contango. The carry market was a headwind for a short position in the double-long DXO note.
The situation should, indeed, be reversed when the market returns to backwardation. A deepening inversion should boost returns for the double-long note.
Knowing where you are--or THINK you are--in the cycle helps you determine the ideal approach.
On Feb 21 05:44 AM GOEBOC wrote:
> Then, what is the conclusion in a backwardation situation, is it
> that you must buy the double long etn instead of shorting the double
> short? That is it?
Thanks for the article. Can you please aid my understanding on how DXO is priced?
Is it priced based on supply/demand of the DXO notes themselves (i didn't think so) or from movements in the Deutsche Bank Liquid Commodity Index (DBLCI)?
If it's the later how come the price of DXO can move one way and yet on the same day the DBLCI move the other? Is that somehow related to the monthly TBill index return.
Also, since these are notes and do not represent a claim on hard commodities (versus say ETF such as USO), how is counterparty risk priced into the price of these notes? In the wake of financials being nationalised/bailed out i wouldn't discount the possibility of any of these finanicals going under.
If the DBLCI goes up 50% then does OLO go up 50%? In which case if DBLCI goes down 50% does OLO go down 50%? Then you could have OLO go from say 100 to 150 to 75. A net of down 25, i.e. it will drift down over time.
Sorry if the above isn't very clear but I hope you get the drift of my questions.
Thanks again for your help and your articles.
James
DXO, in particular, is based upon the Optimal Yield varient of DBLCI which shops for the best roll target at contract expiration. DXO's mandate is to provide twice the MONTHLY, not daily, performance of the oil index (plus a single slug of T-Bill return). That probably accounts for the pricing disparity you've noted.
As for counterparty risk, the first thing that usually happens when an issuer's troubled is a widening in market maker's spreads.
On Mar 05 01:45 PM jgsgilbert wrote:
> Brad
>
> Thanks for the article. Can you please aid my understanding on how
> DXO is priced?
>
> Is it priced based on supply/demand of the DXO notes themselves (i
> didn't think so) or from movements in the Deutsche Bank Liquid Commodity
> Index (seekingalpha.com/symbo...)?
>
> If it's the later how come the price of DXO can move one way and
> yet on the same day the DBLCI move the other? Is that somehow related
> to the monthly TBill index return.
>
> Also, since these are notes and do not represent a claim on hard
> commodities (versus say ETF such as USO), how is counterparty risk
> priced into the price of these notes? In the wake of financials being
> nationalised/bailed out i wouldn't discount the possibility of any
> of these finanicals going under.
>
> If the DBLCI goes up 50% then does OLO go up 50%? In which case if
> DBLCI goes down 50% does OLO go down 50%? Then you could have OLO
> go from say 100 to 150 to 75. A net of down 25, i.e. it will drift
> down over time.
>
> Sorry if the above isn't very clear but I hope you get the drift
> of my questions.
>
> Thanks again for your help and your articles.
>
> James
If the price of DXO is also based on TBills does that mean that it also has interest rate risk (sorry if wrong term)? With interest rates being so low would that risk be quite high longer term, i.e. interest rates increase therefore TBill value goes down and therefore negatively impacting DXO? Is there a correlation between DBLCI and interest rates?
DXO seemed to trade near the 30 mark for a while when oil was at $147 in July 2008. Now oil is hovering in the $40's and yet DXO is around $2, i.e. approx a 3.5 times drop in oil but approx a 15 times drop in DXO. (The graphs I've found of ^DBOLIX only go back as far as Oct 08). I wonder if this is due to the bias downwards for similar percentage gains versus losses that i noted in my example on my last post?
Thanks for the tip re the market makers spread. I shall watch for those.
cheers
James
On Mar 05 02:54 PM Brad Zigler wrote:
> DXO and its stablemates are based upon the oil subindex of the Deutsche
> Bank Liquid Commodity Index. In addition to the oil return, the ETFs
> reflect the return earned from the T-Bills used to collateralize
> the index futures.
>
> DXO, in particular, is based upon the Optimal Yield varient of DBLCI
> which shops for the best roll target at contract expiration. DXO's
> mandate is to provide twice the MONTHLY, not daily, performance of
> the oil index (plus a single slug of T-Bill return). That probably
> accounts for the pricing disparity you've noted.
>
> As for counterparty risk, the first thing that usually happens when
> an issuer's troubled is a widening in market maker's spreads.
Keep in mind that there were historic contangos recently which really whacked long-only oil fund returns.
On Mar 05 04:40 PM jgsgilbert wrote:
> Thanks for your quick reply Brad.
>
> If the price of DXO is also based on TBills does that mean that it
> also has interest rate risk (sorry if wrong term)? With interest
> rates being so low would that risk be quite high longer term, i.e.
> interest rates increase therefore TBill value goes down and therefore
> negatively impacting DXO? Is there a correlation between DBLCI and
> interest rates?
>
> DXO seemed to trade near the 30 mark for a while when oil was at
> $147 in July 2008. Now oil is hovering in the $40's and yet DXO is
> around $2, i.e. approx a 3.5 times drop in oil but approx a 15 times
> drop in DXO. (The graphs I've found of ^DBOLIX only go back as far
> as Oct 08). I wonder if this is due to the bias downwards for similar
> percentage gains versus losses that i noted in my example on my last
> post?
>
> Thanks for the tip re the market makers spread. I shall watch for
> those.
>
> cheers
>
> James
>
>
Just realised I deserve to fail high school math with my % moving up and down question. Less said about that the better.
Yes it seems the contango to backwardation (and vice versa) swing must have a massive impact.
Great if you can pick the bottom but then as Becky Quick, of CNBC, says "bottoms are better for watching then picking".
All the best.
James
DXO is a short term investment vehicle and should be used as such .
Oil is an Inelastic Necessity and perhaps it will become more elastic if gov'ts decide to move aggressively toward renewable energy resources.
"Oil will not go above $50 for another two years because of fallen demand. OPEC will cut, but that will be just enough to prevent a total price collapse to $10. Think $20s.
Short of some sort of war in the middle east. But Obama is not Bush"
Obama sent 30,000 troops to Afghanistan , and promised to have all the troops home from Iraq within 6 months. He is the biggest liar ever to be president. Every pre- election promise he made he has broken.
If you're concerned about an issuer going under and reneging on its debt obligations, then ETNs are definitely O-U-T for you. Scratch the DB notes in favor of exchange-traded funds that hold futures instead.
If the effects of contango are noisesome, then your logical alternative is the United States 12-Month Oil Fund (NYSE Arca: USL). USL rolls expiring futures into the optimal delivery over the ensuing 12 months in an effort to minimize negative roll yields and maximize positive yields.