With the summer driving season just around the corner, surging GDP growth around the world, and another earnings season off to an impressive start, more and more investors are taking a closer look at oil markets. As OPEC begins to once again flex its collective muscle and demand from emerging markets continues to build, some see crude prices surging in coming months, perhaps teasing the $100 per barrel level last touched in September 2008.
Historically, investors looking to make a play on rising oil prices did so through equities of energy companies that often enjoy a jump in profitability when crude prices spike. But the rise of the ETF industry has changed the way many investors approach commodity investing, bringing many securities that were once available primarily to institutional traders within reach. While exposure to spot oil prices still isn’t readily available, the development of futures-based commodity products allows more direct exposure to one of the world’s most widely-used resources.
Two of the most popular exchange-traded commodity products available to U.S. investors offer exposure to crude oil. The iPath S&P GSCI Crude Oil Total Return Index ETN (NYSEARCA:OIL) and United States Oil Fund (NYSEARCA:USO) had aggregate assets of more than $2 billion at the end of the first quarter, and are two of the most popular ways to gain exposure to oil prices. While the risk/return profiles presented by these two ETPs are generally similar, there are both subtle and not-so-subtle differences that can potentially have a big impact on returns and volatility.
The biggest difference between USO and OIL is in the structure of each. OIL is an exchange-traded note (ETN), meaning that it is a senior, unsubordinated, unsecured debt security that is linked to the total return of a market index (in this case, the S&P GSCI Crude Oil Total Return Index). The benchmark to which OIL is linked is a sub-index of the S&P GSCI Index and reflects the returns that are potentially available through an unleveraged investment in West Texas Intermediate (WTI) crude oil futures contracts plus the T-Bill rate of interest that could be earned on uninvested cash.
USO, on the other hand, seeks “to reflect the changes in percentage terms of the spot price of light, sweet crude oil…as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the [NYMEX].” To accomplish this goal, USO invests in NYMEX futures contracts and cash (the daily holdings are available here). So since USO actually holds the assets from which the returns of OIL are derived, the returns will generally be highly correlated, but not identical.
It’s important to understand the risks and benefits of investing in an ETN. While it’s unlikely that Barclays Bank, the issuer of OIL, will go bankrupt, credit risk should never be completely ignored (as investors in ETNs issued by Lehman learned the hard way). So that’s the downside of investing in an ETN; if the issuer goes under, investors get in line with the rest of the creditors. If United States Commodity Funds were to go under, investors in USO would have claim to the fund’s underlying assets.
On the flip side, since there are no assets to manage ETNs will generally have lower tracking error and sometimes lower expense ratios. Whereas USO must roll its holdings each month–which means going out into the market and buying and selling securities–the value of OIL is a simple calculation based on market prices. Overhead and potential for tracking error are minimal.
Both OIL and USO charge higher expense ratios than most energy ETFs that consist of big oil firms. USO charges a total expense ratio of 0.96%, while OIL’s annual fee is 0.75%. By comparison, the Energy Select Sector SPDR (NYSEARCA:XLE) charges 0.21%.
Returns / Correlation
Crude Oil Correlations
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Since OIL was launched in August 2008, the correlation with USO has been nearly 1.0. Moreover, the correlation of both USO and OIL to spot prices for West Texas Intermediate crude oil has been strong as well; both approach 0.90. While both USO and OIL generally move in the same direction as crude prices, the magnitude is often very different. Changes in the spot prices of the underlying commodity impact the return of a futures-based strategy, but so do a couple other factors. Most importantly, the slope of the futures curve can be a major determinant of returns to both USO and OIL.
When markets are backwardated (i.e., long-dated contracts are cheaper than next month futures), futures-based products will generally outperform spot prices. But when futures markets are contangoed, the roll yield can erode returns, causing a big return gap (for more on the effects of contango on returns, see What Every Investor Should Know About Commodity ETFs or How Contango Impacts ETFs).
Both USO and OIL have lagged far behind hypothetical returns on spot oil prices over the last four years. This isn’t because they’re flawed products, but rather because they use futures contracts to gain exposure to oil prices. As shown below, the oil ETFs actually outperformed spot WTI when crude prices plummeted in 2008. So investors should be aware of the nuances of futures-based investing; while products like USO and OIL will generally move in the same direction as the underlying commodity, they’re not guaranteed to track movements in spot prices (and often won’t come close over extended periods of time).
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For investors looking to bet on a run-up in oil markets, both USO and OIL present similar exposure. Each fund has potential drawbacks and advantages, so it’s hard to declare one as universally better than the other. As always, take a look under the hood before driving off to make sure you know exactly what you’re getting into.
Disclosure: No positions at time of writing.
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