By Lara Crigger
Earlier this week, US Commodity Funds — best known for its $1.7 billion US Oil Fund (NYSEARCA:USO) and $2.8 billion US Natural Gas Fund (NYSEARCA:UNG) — launched the country's first ETF holding non-US-produced crude oil.
The new fund, the US Brent Oil Fund (NYSEARCA:BNO), focuses on Brent crude, a light sweet oil produced in Europe's North Sea. After WTI Crude, Brent futures are the second-most liquid commodity contract in the world, and Brent is often used as a pricing benchmark for much of the world's oil.
Shortly after launch, HAI Associate Editor Lara Crigger sat down with USCF's chief investment officer and portfolio manager, John T. Hyland, to discuss the new fund, as well as why investors should start thinking about their oil exposure in global terms.
Crigger: So why invest in Brent crude oil over WTI? Isn't all oil the same?
Hyland: Admittedly, owning WTI contracts at the front end of the futures curve is quite similar to owning Brent contracts at the front end of the futures curve. But there are a few ways in which they can be different.
Even though the prices of Brent and WTI tend to move in close synchronization, Brent prices are a bit more attuned to the global market, while WTI is more attuned to the North American market. Even though the majority of American investors will probably be more interested in the American component, we think some will have an interest in looking outside the US for exposure.
Also, WTI is sometimes impacted more by storage constraints in Cushing, Oklahoma. If the storage capacity in Cushing starts to fill up, then that can have an impact on the shape of the futures curve for the WTI contract, because it's based out of there. So the front month or two of WTI oil could be in a flatter backwardation or steeper contango than oil elsewhere, simply because of the storage issue.
Crigger: And since Brent is carried by tanker, it wouldn't be subject to the same single-point storage concerns.
Hyland: Precisely. So, clearly, there will be some times when that dynamic would favor Brent over WTI, and maybe there will be times when WTI would be favored over Brent. We're not saying that for all times and all purposes, one is better than the other.
People often ask me which is the better fund, USO or USL? Well, that's the wrong question. Clearly, there will be times when it will be better to be exposed to the front end of the curve, and other times when it's better to be exposed to the 12-month curve. Likewise, there will be times when Brent will be less in contango or more in backwardation than WTI, and the other way around.
So we view the funds as more tools for an investment toolbox. I mean, compared to where we are with equities or even fixed income in the ETF space, the commodity area is still filling in some of its basic tool set. Just four years ago, if you wanted oil exposure, you had one choice: USO, at the front end of the WTI curve. And obviously that's still a popular place to be, because it trades 20, 30 million shares on a good day. But now, four years later, you can be there; you can be spread across 12 months; you can be floating or inverse or double up; and now you can be in non-WTI — Brent.
Crigger: Certainly there's still room for more development—more variations on Brent, or even Argus sour crude, or Dubai.
Hyland: Absolutely. If you were to look at the 20 most actively traded futures contracts in the world, about half of them don't have an ETF or ETN in the US that gives you any direct exposure. And forget having things like having a 12-month fund versus a floating month, or inverse or levered. So we need to keep adding choices to the tool kit.
Crigger: Why do you think it took so long for a Brent exchange-traded product to come to market?
Hyland: It took us this long because we're one of the smaller shops. Some ETF firms can throw 20 ETFs against the wall to see what sticks, but it is a little more complicated to shepherd the commodity-related products through the registration process, and maybe that discourages the shotgun approach.
Hyland: You think we work faster than we do. Yes, we do have 12-month oil and 12-month natural gas, so it will always be at the back of our mind. But it's a question of at what point do we decide to spend the money to bring it to market — and will there be enough interest to keep it to market? You don't want to bring an ETF to market, and five years later, it still has $10 million in assets. But certainly, we would always give thought to a 12-month, or even an Argus sour crude or Dubai ETF.
Crigger: Recently, we've seen front-month-only funds like USO and UNG get slammed in rollover during times of contango. As a similarly structured front-month-only fund, will BNO be subject to the same forces, and how do you plan to deal with it — if at all?
Hyland: BNO is what it is. It's designed to hold on to its position at the front month of the curve, and clearly, there will be times when the front end of the curve will be in contango, vs. backwardation.
At the same time, if you look over the past few years, you'll see that if Brent's in contango, then WTI's in contango; if Brent's in backwardation, WTI's in backwardation. They move closely in that sense. But over the past two years, there have been these periods where, as I mentioned before, there's an especially large buildup of inventory in Cushing, Oklahoma, and contango gets very steep for WTI.
But that doesn't necessarily translate to crude oil away from Cushing. Oil in the West Coast, Gulf Coast, in the New York harbor — they could all be in less contango than Cushing. And Brent, obviously, can be in the same position. If you look at the shape of the futures curve, between month one and month two — and bear in mind the recent inventory reports for Cushing show a buildup there — WTI is in a steeper contango than Brent.
Again, that is not to say in all seasons, and in all years, Brent is always a better place to be. It's just an alternative. Sometimes one will do better, sometimes the other.
Crigger: Is Brent's exposure to the global oil markets a double-edged sword? That is, how much exposure does Brent have to, say, what's going on in the euro and the current turmoil in the European economy?
Hyland: Conceptually, oil in the North Sea fields is probably disproportionately consumed in Rotterdam and other refineries in northwest Europe, so some of them are going to be more sensitive to the economic conditions outside North America. And Brent is traded in London, so it's going to be more influenced by events in Western Europe than WTI would be.
That said, unlike some other energy commodities, cargoes move fairly freely. So if Brent prices get too far out of line with oil prices in North America, then instead of having the tanker go to Rotterdam, it can just go to New Jersey. So it's not a night or day thing, like it could be with natural gas in the US. There, the natural gas market in the US is physically disconnected with the natural gas market in Europe.
Crigger: The debate over increasing regulation in the commodities space continues: So how would the adoption of fixed position limits on energy futures, or using clearinghouses for OTC transactions, affect BNO?
Hyland: Well, BNO is a London-based futures contract, so it's actually not part of the position limit discussion currently going on in Washington. And the Financial Service Authority — their version of the SEC and the CFTC rolled into one — has made clear that, insofar as the FSA has oversight over the trading of these derivatives, they're not a proponent of position limits. That is, they're not really sure that there's a problem to solve, and if there is a problem, they're not sure that position limits work to resolve that problem.
Crigger: That's a very marked difference than the discussion going on in D.C. right now.
Hyland: They've also said that they don't understand why you would have position limits on financial buyers, but not on physical buyers. In the US, you don't put limits on physical players and hedgers, but the FSA says they don't see any evidence that financial buyers and sellers are any more likely to be manipulators, or cause problems, than physical users. So if there's not a difference in the two in their propensity to cause problems, then why restrict one but not the other?
Brent is an FSA-regulated product. There are no position limits on Brent, and no formal accountability levels. Could it become part of a greater regulation discussion, like the one going on in the US? Of course. But there's nothing on the horizon that points to it becoming an issue.
Disclosure: No positions