USO vs. BNO: Explaining the Big Gaps in Oil ETF Performance

Includes: BNO, USO
by: Michael Johnston

By now, many investors are well aware of the potential impact of the nuances of futures-based commodity ETPs. Contango-ed markets can cause fund returns to lag behind a hypothetical return on spot prices, sometimes by a fairly wide margin.

But a look at the recent history of the Oil & Gas ETFdb Category reveals another performance gap that has an intriguing explanation; recently, the United States Oil Fund (NYSEARCA:USO) was down about 1% on the year, while the United States Brent Oil Fund (NYSEARCA:BNO) was up about 13%.

In other words, the performance delta between these two products over the last seven weeks or so was about 15%–a considerable gap considering that the underlying holdings have historically exhibited a very strong correlation.

Crude Oil 101

Though there are hundreds of different grades of tradeable crude oil, only a few of them matter to investors. Brent, the blend underlying the futures contracts held by BNO, is one widely-followed benchmark contract. West Texas Intermediate, the commodity behind futures held by USO, is another. Brent blend is a combination of crude oil from 15 different oil fields in the Brent and Ninian systems located in the North Sea, making it a “light” crude oil but not as light as WTI. Brent is typically refined in northwest Europe, and is ideal for making gasoline and middle distillates.

West Texas Intermediate is generally refined in the Midwest and Gulf Coast regions of the US. WTI is sweeter and lighter than Brent, making it easier and cheaper to refine into gasoline. WTI futures trade on the NYMEX, and the contract is a widely-followed global benchmark–at least for now.

Because it is easier to refine, WTI has historically traded at a slight premium to Brent. According to the U.S. Energy Information Administration, “WTI is generally priced at about a $5 to $6 per-barrel premium to the OPEC Basket price and about $1 to $2 per-barrel premium to Brent”. But lately, the relationship between WTI and Brent has taken an odd twist, with some potentially wide-ranging implications for oil pricing conventions.

In recent weeks the gap between Brent and WTI prices has surged to almost $20 per barrel, after the two grades of crude have moved in near perfect unison for several decades. The disconnect began to materialize last year amidst rising inventory levels in Oklahoma, as the U.S. economy sputtered while other markets resumed growth. The gap accelerated in late January when tensions began to flare in the Middle East. Because a significant portion of oil trading in Europe comes from the Middle East, the escalation of geopolitical risk in Egypt caused the price of Brent to quickly surpass WTI and top the $100 mark.

Whereas the protests in Egypt were relatively peaceful, the eruption of violent conflicts in Libya have rekindled concerns about supply disruptions in the region. Muammar Gaddafi has recently lashed out at a growing and seemingly strengthening opposition in recent days, reportedly instructing his followers to sabotage the country’s oil assets in an attempt to cut off a strategic asset that had fallen under the control of the revolutionaries. Libya is Africa’s third largest oil producer, and worries that production will soon be cut off sent prices surging higher in Tuesday trading. Brent finished yesterday’s sessions at nearly $106, a premium of about $12 to WTI.

Brent has surpassed WTI before, but the gap has never been as significant as it has become in recent sessions. And while WTI contracts for delivery in Oklahoma haven’t yet topped the psychologically-important $100 per barrel mark, end user products such as gasoline have already topped levels associated with that threshold. “While U.S. prices haven’t scaled such heights—the benchmark oil contract on the New York Mercantile Exchange briefly surged Tuesday past $94—many U.S. oil refiners and consumers are finding their costs have already escalated,” writes Jerry DiColo.

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Arbitrage Opportunity?

If historical pricing patterns resume and Brent’s premium eventually dissolves, the current environment would create an arbitrage opportunity for investors. If order returns to Egypt and a “revolution contagion” fails to spread throughout the region, the premium could disappear and even revert back to a discount relative to WTI.

But not all analysts are convinced that the current ratio is a temporary aberration. Many believe that Brent has become a more reliable indicator of global demand, and many energy products–such as gasoline–have followed Brent higher even as WTI has slumped. “That has led some investors to believe they could be seeing the beginning of the end of WTI supremacy, with Brent taking its place as the most widely used marker for pricing an array of crude grades across the globe,” writes Claudia Assis. If that is indeed the case, it could have some interesting ramifications across the commodity ETF space. WTI is currently widely-traded, serving as the basis for most futures contracts and commodity ETPs. If that “benchmark dominance” is nearing its end, BNO could see its importance and assets surge.

“This situation is a lesson of futures markets that work,” writes John Kilduff. “While WTI continues to be an important part of the global energy markets, it will not completely disconnect from its local market dynamics, nor should it.”

The events of recent days seem to indicate that geopolitical uncertainty in the Middle East will linger for the foreseeable future, perhaps meaning that a delta between BNO and USO may hang around as well. Whether we are witnessing the dying days of WTI as a benchmark oil contract remains to be seen, though such a development seems unlikely regardless of recent price patterns. The widening gap between these funds has created an intriguing but risky trading opportunity.

Stay tuned to see how this one ultimately plays out.

Disclosure: No positions at time of writing.

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