Oil often makes news during the summer driving season as fuel prices ramp up with increased demand. Lately, Texas Tea has been getting even more than its usual airplay because of the Libyan crisis and the unexpected release of strategic oil reserves.
More news about oil, or more properly “OILZ,” came down the pike in June when investment bank UBS unveiled the latest exchange-traded product (ETP) designed to combat a problem that has bedeviled oil investors for years.
To understand the significance of this new note, you first have to understand the problem. It arises from the bull market in oil. The average price of West Texas Intermediate (WTI) crude oil — the light, sweet grade favored for domestic gasoline production — has risen by 24 percent over 2010's level, making the commodity one of the year's best investment opportunities. Sounds like an ideal market in which to hold a long position, right?
But you have to keep in mind that “opportunities” are just that; they don't always produce profits, especially when oil is involved. Why? Unless you have the ability to buy and store large oil cargoes, your petroleum investment will, in all likelihood, have to pass through the futures market. Unlike stocks, futures contracts have expiration dates and must be rolled over from one delivery month to another to maintain continuous investment exposure. And therein lays the roadblock to profits: contango.
Contango and Backwardation
Contango describes the shape of the oil futures curve when nearby contracts trade at lower prices than deferred deliveries. As an example, there's a $2 contango if August futures are traded for $93 a barrel while November sells for $95. For storable commodities such as oil, contango reflects a market surplus, i.e., there's enough oil to bank, or carry forward, for future sales. The price spread represents per-barrel financing, storage and insurance costs. The WTI market slipped into contango in June 2008, presaging the global economic swoon and a plunge in oil demand.
If you're wondering from what state the oil market slipped, it was backwardation, the polar opposite of contango. An oil market is inverted, or backwards, when nearby prices are higher than deferreds, e.g., when August sells for $95, but November's at $93. Most often, a market inverts when supplies are tight; nobody wants to wait for a delivery in a backward market, they want their oil now. There are no carrying charges in an inverted market, implying that no oil is being added to storage.
To understand the effect contango and backwardation have on investment profits, think of what a fund manager must do to maintain a bullish posture in oil. Holding a long position into a contract's expiration month exposes the fund to an unwanted delivery. Investment funds aren't geared for moving and storing 1,000-barrel lots of physical crude so, when its contracts approach expiration, its managers will roll the positions forward along the curve. By selling its soon-to-expire nearby contracts and replacing them through the purchase of later-dated futures, the fund can avoid delivery. But if the fund makes its move in a carrying charge market, say by selling August at $93 and buying November at $95, a negative roll yield will be realized. It only takes a few of these negative rolls before the contango headwind knocks down any profits won by the fund's long oil position.
ETPs vs. Contango
Contango's zephyr has been particularly strong during the lifespan of the United States Oil Fund (USO), the first exchange-traded product to hold constant exposure to the front-month WTI crude oil contract. Launched in April 2006, USO's value sunk 45 percent while spot crude rose by 39 percent.
The persistence of oil's contango has prompted exchange-traded-product sponsors to design indexes with roll methodologies that minimize negative roll yields. The first contango-fighting ETF rolled out in January 2007 when PowerShares debuted its DB Oil Fund (DBO). DBO tracks a rules-based index that attempts to squeeze the best roll yield out of the futures term structure. When the DBO portfolio performs its monthly roll, the index “shops” for the most positive, or least negative, yield obtainable from the next 13 WTI delivery months.
DBO's shopping trips have paid off with a gain of 18.5 percent since inception. Crude oil, however, jumped 69.5 percent, so contango's deleterious effect may have been mitigated by yield optimization, but it wasn't eliminated.
A different approach to the contango problem was adopted by a sibling of USO, the United States 12 Month Oil Fund (USL), when it was introduced in December 2007. Instead of holding and rolling a single position in the spot contract, USL spreads its exposure evenly over the first 12 delivery months on the futures curve, reducing the front-end roll impact. USL definitely made things better for long oil investors.
Better, but not good. Since USL's launch, the ETF's given up 15 percent of its value while WTI's wobbled to a 6 percent gain. Though USL lost money, it still looks like a bargain compared to the contemporaneous 48 percent slump in USO's value (see Figure 1).
The next round of innovation came in February 2011 when the Teucrium WTI Oil Fund (CRUD), was floated. Unlike USO, DBO and USL, which roll their positions monthly, CRUD repositions only twice a year and attempts to provide broad exposure to the futures curve by dividing its contract allocations into three maturity buckets:
- 35 percent to the nearest-to-spot June or December WTI contract;
- 30 percent to the following June or December contract; and,
- 35 percent to the December contract following the second (#2) allocation.
To date, CRUD's returns have been middling. Through June 30, the fund lost 5.4 percent, compared to WTI's 2.7 percent dip, splitting the difference between USO's 6.4 percent loss and USL's 4.5 percent give-up. CRUD's track record fairly well matches the 5.5 percent loss sustained by DBO.
Just two months after CRUD's introduction, Barclays Bank issued a suite of commodity exchange-traded notes (ETNs) based upon its so-called “Pure Beta” methodology, including one tracking crude oil. The index driving the value of the iPath Pure Beta Crude Oil (OLEM) seeks out the WTI contract “most representative” of oil returns. Each month, the Pure Beta methodology rolls the note's exposure into the contract month that most closely tracks an open-interest-weighted average price for the front 12 WTI delivery months, subject to liquidity and dislocation filters. “Dislocation” here refers to price distortions caused by short-term supply and demand factors, such as severe weather conditions, strikes, etc.
In its first 50 trading days, OLEM's lost 15.7 percent, a bit worse than the 15.2 percent loss in the WTI front month price, but better than the 16.5 percent setback suffered by USO. Both DBO and USL, with losses of 14.9 percent and 13.9 percent respectively, outperformed OLEM.
OILZ Capitalizes on Contango
Clearly, contango's been a pretty tough problem to lick. Its intractability prompted the development of the ETRACS Oil Futures Contango ETN (OILZ), which began trading in mid-June. (OILZ was launched simultaneously with a companion tracker, the ETRACS Natural Gas Futures Contango ETN, or GASZ).
OILZ is linked to the performance of the ISE Oil Futures Spread Index which provides a 100-percent short exposure in the front month WTI contract and a 150-percent long exposure in mid-term — namely the sixth, seventh and eighth month — deliveries. The spread index effectively replicates a so-called “calendar spread” — a position favored by traders who bet on the expansion and contraction of the oil market contango.
OILZ, unlike the other exchange-traded products we've examined, is only obliquely directional with respect to the absolute price of oil. (You could argue that, subject to the overweight on the long side, a bear market could actually be good for OILZ holders as a growing surplus of WTI would mostly likely be reflected in steeper carrying charges.) The other products aim to “lose less” ground when contango's zephyr blows; OILZ intends to skate with the wind and make money as the spread widens.
OILZ, in fact, did just that in its first two weeks of trading. With the contango breeze freshening at its back, the ETN's market price rose 40 basis points though its underlying spread index gained 63 basis points. OILZ is thinly traded — an average of just 400 shares change hands daily — so its last sale price can sometimes seem out of step with the ebb and flow of oil's carry market.
That illiquidity is commonplace in ETNs. The OLEM note, for example, traded a daily average of 500 shares in June, creating an apparent 57-basis point discount between the note's indicative value and its market price.
We can't make too much of OILZ's performance after just two weeks. After all, some oil ETFs actually fared better than OILZ in late June: USL and DBO rose 72 basis points and 116 basis points respectively, influenced in great part by a 49-basis point appreciation in the price of spot WTI. Time will tell if the new note is any better than the other ETPs in consistently wringing profit from a widening contango.
Winning the Battle?
There's evidence that each successive product innovation has managed to trim contango's deleterious effect upon long oil exposures. We can see that clearly when we stack up the oil ETPs' annualized performance versus WTI (see Table 1).
Granted, the performance of the three recently introduced ETPs is based on a relatively short string of data points. We have to look at those numbers with a certain degree of caution. Still, there's no denying that headway has been made in harnessing contango. The question left for advisors and investors to ponder is whether these products will have any utility if the oil market flattens or heads south in earnest.