Seeking Alpha
Profile| Send Message| ()  

Let me begin by stating that this article will, at no time, provide evidence or insight about how I believe the oil markets will behave in the future. Rather, my purpose is to provide current and potential energy investors a means to take advantage of glaring market inefficiencies given some prior understanding or opinion of the crude oil markets. As such, if you were looking for a hot oil tip, this article is not for you.

Still with me? Great, let's get to it.

I have previously written about why commodities ETFs are terrible. Let me assure you that this article by no means represents a reappraisal of that opinion. In fact, it is the abject terribleness of commodities ETFs that makes the strategy I outline here viable in the first place. As a brief recap, commodities ETFs are terrible because they do not do the thing they are supposed to do, namely, track the price of an underlying commodity. These instruments, for the most part, hold the front-month futures contract for a commodity.

Shortly before that contract's expiry, the fund must sell and replace that contract with a longer-dated contract. Typically, longer dated futures trade at a premium to near expiration contracts, a situation generally referred to as "contango" (that nomenclature is technically not correct, but most people still call it that, so it'll do for our purposes). That means that every month, the fund is selling one contract and buying another, more expensive contract. ("Commodities ETFs: Buy high, sell low.™") The result of this strategy is that the vast majority of the time investors in commodities ETFs pay a significant penalty every month to this negative roll yield.

Here, just take a look at how the tremendously popular United States Oil Fund (USO) has fared over the last nine months against the underlying Crude Oil futures to which it is supposedly pegged:

(click to enlarge)Percent change in Crude vs USO

That's right, crude oil has gone up about 16% since July 2012, while USO has only seen a climb of a little more than 10%. This is entirely because of the roll-yield penalty that USO pays every month. This is why I hate commodities ETFs.

There's another side to this coin, contango's opposite: "backwardation" (again, not technically the correct term, but it's the word everyone uses, so we'll do the same). When a market is in backwardation, long-dated futures contracts are less expanse than those near expiration. In this situation, a fund that rolls the front-month contract would actually receive a bonus as a more expensive contract is replaced with a cheaper one. Obviously, this situation is preferable for investors with a long position in the fund. Unfortunately, an investor cannot choose when a commodity is in contango or backwardation. When it comes to oil, however, we do at the very least have a choice of crudes.

The two primary crude oil contracts traded in global markets are "West Texas Intermediate", which is what the American media generally refers to when reporting the price of crude, and "Brent Crude", which is the British benchmark. I've written previously about the relationship between the two crudes, which itself is an interesting and complex discussion, but for our purposes, the most salient point is that, in general, the prices of the two oils are highly correlated (to the tune of an R-squared greater than .90 historically, and .784 since the start 2012).

Here's a chart of the two oils' prices from June of 2010 until early April 2013:

(click to enlarge)Brent and WTI prices over time

Brent crude, naturally, has its own ETF, the United States Brent Oil Fund (BNO) which operates equivalently to USO, holding and rolling only the front-month contract of Brent crude (you can read the prospectus here). For the majority of the last twelve months, Brent crude has been in backwardation. As such, holders of BNO have reaped a steady bonus relative to the price of Brent. See for yourself:

(click to enlarge)% Change in Brent Crude and BNO

Or, for a more direct comparison between the two funds, here's a screen grab I took from Google Finance comparing USO and BNO since the latter's inception:

(click to enlarge)USO and BNO since 6/2010, screen shot from Google Finance

BNO has increased in value some 61% since June of 2010, while Brent has gone up only 41%. USO, on the other hand, has gone up to the tune of 3.8% while West Texas Intermediate has increased 27%. And remember, these funds hold nothing but the front-month futures contracts of their respective crude types.

To take a short term example, consider the three-month price movements of USO and BNO from September through November of last year:

(click to enlarge)USO and BNO, 9/2012 - 12/2012, screen shot from Google Finance.

During that time, Brent crude dropped some 3% while BNO only fell 1.4%. However, WTI fell 7%, while USO dropped some 9%, again, in both cases because of the roll yield. Here consider a short seller; over this period she would have been much happier with USO.

So, with that all laid out, the strategy for playing the oil markets with ETFs is straightforward: If you're bullish on oil, go long BNO. If you're bearish, short USO. If you're neutral, or expect no change in oil prices whatsoever, do both.

I am, of course, aware that my advice essentially boils down to shorting when bearish and buying when bullish, which in itself is nothing earth shattering, but the nature of commodities ETFs creates a subtle distinction for when any one behavior is wise or unwise. The rules could be stated more broadly (and more proscriptively) as "never buy a commodities ETF where the underlying futures are in contango, and never short a commodities ETF where the underlying futures are in backwardation". (Though with that phrasing, you miss somewhat the not insignificant roll-yield bonus from shorting a fund whose contracts are in contango and/or going long a fund whose contracts are in backwardation, but you get the idea.)

Before you go trading, there are two major caveats to be aware of:

First, the correlation between Brent and WTI. If you go back to that WTI vs Brent chart and look at the price movements towards the beginning, you'll notice that Brent began pulling away from WTI at the end of 2010. For myriad reasons, back in 2011, the correlation between Brent and WTI dissipated, with their correlation (as measured by R-squared) falling from .99 to .525. Since 2011, however, the two crudes have been moving back towards a tighter correlation. As Brent and WTI are literally two versions of the same thing, it makes sense that their prices would be highly correlated. This is why, over time, investors in one experience the same highs and lows as investors in the other. However, as evidenced by recent history, the two oils can and sometimes do fall out of correlation. In the very long term, the correlation between the two oils should persist, but investors need to be aware of this.

Second, the persistence of contango and backwardation in WTI and Brent, respectively. In general, most commodities exist in a state of contango. This, again, is why commodities ETFs are terrible. That Brent has stayed in backwardation so long is definitely interesting, and while I don't pretend to know enough about geopolitics to explain why the situation has persisted, as evidenced above, investors in BNO have certainly reaped the benefit.

This is all to say, however, that this situation is by no means guaranteed. Whether Brent's state of backwardation has been a year long-anomaly, or in fact represents a new norm for the British crude, I cannot say, and in fact, earlier this month Brent briefly slipped into contango, though as of writing, the market appears to have returned thoroughly to backwardation. The point is, there is nothing to say that such a situation will persist, or even that WTI won't move out of contango into backwardation. An investor looking to employ the strategy outlined here needs to be diligent in keeping apprised of the market's situation.

So there you have it. Somewhat ironically, the general awfulness of commodities ETFs has created an exploitable inefficiency. To be clear though, this is by no means an arbitrage situation; if crude were to bottom out suddenly, a holder of BNO would not be immune to an absolute loss. The point, rather, is that the multiple options that currently exist in the oil ETF market allow for more intelligent calculations of risk which, in the end, is the best most of us can do.

Someday, perhaps, commodities ETFs will exist that actually track the price of the commodity they represent. Until then, it's important we understand how they can still be used to our benefit, even as we continue, rightfully, to ridicule them.

Source: How To Play The Oil Market With Commodity ETFs