Spot Oil Funds: One in the Hand Is Better than One in the Bush

By Paul Amery

A bird in the hand is worth two in the bush, as the old saying goes.

In the ETF/ETC world, it turns out that owning a barrel of oil is also much better than owning a claim on a barrel of oil for delivery in a month’s time, or at least it has been for most of 2009.

As Source reminded us yesterday when issuing a new oil ETC, the return on spot NYMEX WTI oil (the price for immediate delivery) from year-end to October 31 was 66.16%, while the United States oil fund (NYSE: USO), which tracks a rolling one-month futures position, was up only 10.36% over the same period.

Why? Because of the thorny problem of the cost of carry, a concept that is well understood by investors in fixed income, currencies and commodities, but which often seems to be overlooked in the equity (and, perhaps, ETF) world.

The word “carry” tells us of a historical link to the world of raw materials and storage or shipping, but the term has become much broader in its meaning.

According to Investopedia, the cost of carry “can include financial costs such as the interest costs on bonds, interest expenses on margin accounts and interest on loans used to purchase a security, and economic costs such as the opportunity costs associated with taking the initial position.”

In the case of crude oil and other commodities where there are storage costs, using spot price movements as an indicator of potential investor return is rather misleading. Unless you have a spare supertanker or terminal facility to hand, there’s no way you are going to avoid such costs and these are typically reflected in an upward-sloping forward price curve – or contango (a type of carry). Contango then creates a negative return when a passive investor rolls his position from one forward or futures contract to the next – in effect, you are constantly reinvesting at a higher price.

For other, purely financial instruments, carry reflects the cost of funding an investment position when compared to the income received from it.

Financing a bond when a yield curve is upwardly sloping creates positive carry (as longer-dated interest rates are higher than short ones, you earn more on the bond position than you pay for financing it). Shorting a bond under a similar yield curve shape creates negative carry.

But carry affects equities too, something that’s often forgotten. With most equity markets yielding more than money market rates, you currently get positive carry on an equity forward or future (for example, the S&P December 2009 future’s settlement price last night was 1041.7 and the March 2010 future settled at 1036.8, while the “cash” S&P 500 index closed at 1045.41). In other words, you can buy the S&P for forward settlement more “cheaply” than buying it today since the index dividend yield (just over 2% at current market levels) exceeds near-zero interest rates, and the forward S&P prices have to reflect this interest rate differential.

More broadly, if you buy any exchange-traded product whose index is based on futures contracts or generally any forward pricing of the underlying instrument, there will be a carry component incorporated in the eventual investment return. Commodity, credit and currency ETPs are typically all affected, for example.

In the case of some markets, in which the cost of carry has recently been strongly negative, the effect of carry on a period holding return can far outweigh the component that’s due to the underlying spot price movement. The returns of USO when compared to spot oil, or VIX ETNs when compared to spot VIX, are two cases in point this year.

Should investors avoid exchange-traded products that have this carry component? Not at all, but they need to understand it.

Fundamentally, thinking in “carry” terms is a great way to proof an investment strategy. If you are considering investing in a market where you face a strong headwind through negative carry when rolling positions forward, it’s worth rechecking your assumptions on price movements and whether you really want to go ahead. If you have positive carry then you’ll gain ground over time even before you start to worry about the underlying investment’s price performance.

And, since many studies tell us that dividends are the overwhelming component of long-term equity returns (87% of the total return, according to one piece of research), having an equity yield that beats the returns available on other investments is also a good start for a strategy – as long as the dividend is safe, of course (but that’s another story).

Original post

Comments

[Ermilo:]

That's why I do not invest in ETF's anymore. Play the pure and simple technique, and if you can't handle the heat....stay out of the kitchen. Futures and options are the way to go.

Nov 04 02:15 PM

[Francis Groves:]

Thanks for a very helpful article but I'm not sure if I can apply what I've read to the new Source ETC - that's the S&P GSCI Crude Oil Enhanced TR Treasury Bill Secured (GR:SEWTI), right?

There's no dividend presumably because it's an ETC. However, somebody (the investor?)gets a coupon from those treasury bills and, even if it's only enough to offset part of the management expenses, that counts as positive carry.

I read the factsheet and could not work out how dynamically switching between sixth month future and next month future improved the tracking to being so close to spot price tracking. I guess more will be written about this over the next few weeks and I'm content to bracket that. As far as carry is concerned, does the new ETC have some contango (or roll) negative carry but not as much as all the other crude futures ETCs?

Nov 05 10:31 AM

[Paul Amery:]

hello Francis

I'm sure Source will correct me if I get this wrong but as far as I understand it the T-bills held as collateral do not contribute to the return of the ETCs - in the same way as collateral held by swap-based ETFs does not contribute directly to their return either. It's there as collateral - i.e. as backing for the investors to have recourse to in the case of the failure of a counterparty.

I don't think Source is claiming that their new switching policy will get close to the spot price return, but they do suggest that it will reduce the return drift due to contango. But some negative carry is inevitable given the shape of the oil price curve that has prevailed this year.

We will be writing more about this on the indexuniverse.eu site in the next few days.


On Nov 05 10:31 AM Francis Groves wrote:

> Thanks for a very helpful article but I'm not sure if I can apply
> what I've read to the new Source ETC - that's the S&P GSCI Crude
> Oil Enhanced TR Treasury Bill Secured (GR:seekingalpha.com/symbo...),
> right?
>
> There's no dividend presumably because it's an ETC. However, somebody
> (the investor?)gets a coupon from those treasury bills and, even
> if it's only enough to offset part of the management expenses, that
> counts as positive carry.
>
> I read the factsheet and could not work out how dynamically switching
> between sixth month future and next month future improved the tracking
> to being so close to spot price tracking. I guess more will be written
> about this over the next few weeks and I'm content to bracket that.
> As far as carry is concerned, does the new ETC have some contango
> (or roll) negative carry but not as much as all the other crude futures
> ETCs?

Nov 05 02:06 PM

[Francis Groves:]

Thanks for that.

The new Source ETC certainly seems to track the spot price very well, according to Source's own chart. But that's mostly projecting back what their ETC would have done if it had been around in the last year or two. So maybe they just tried out various roll strategies to see which produced the best fit, which doesn't necessarily mean their one month contract/six months contract will continue to do so going forwards, I suppose.

Nov 06 11:28 AM