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By Stephen D. Simpson

The world still largely runs on crude oil, and that ever-present demand coupled with erratic shifts in supply, makes it a volatile, liquid and popular instrument for investors, traders and speculators alike. Savvy individuals have always had the option to try to play oil prices through the equities of multinational energy companies and/or smaller independent exploration and production (E&P) companies, as well as actual oil futures themselves.

These instruments have notable drawbacks, though, including imperfect correlation to actual oil prices (for the energy company stocks) and high margin requirements (for oil futures). Enter oil ETFs. These products give traders many of the advantages of direct investment in oil, but in a vehicle that is much more convenient for the average individual investor.

What’s Your Objective?

Energy and oil ETFs can be broadly organized by the stated objective of the fund manager. Some funds are built to track broader commodity indices, of which energy may be a large component. Other funds focus exclusively on energy, but look for a broader approach by combining crude oil, natural gas, heating oil and gasoline futures into the mix. Last but not least are those funds that commit themselves exclusively to a single type.

WTI, aka West Texas Intermediate, is the most common benchmark for oil ETFs. WTI is the benchmark for the NYMEX oil futures contract and the most commonly-used oil benchmark in the financial markets (in terms of trading volume). When the financial news reports (at least in North America) mention the price of oil, they are almost exclusively referring to WTI [see also Crude Oil Guide: Brent Vs. WTI, What’s The Difference?].

While WTI is the benchmark of choice in North America, Brent crude is actually more common around the world. Not only is Brent the benchmark for oil futures in London, but most oil and fuel contracts in Europe, Africa, and the Mideast are benchmarked to this version of crude.

Mind The Structure

Prospective oil ETF investors also need to pay attention to the structure of the investment they are considering. Which contracts a fund buys, and how often the manager has to turn them over, not only impacts the performance of the fund (trading costs money), but also alters the price exposure and correlation.

The U.S. Oil Fund (NYSEARCA:USO), the largest and most liquid oil ETF, largely uses front-month contracts. This makes the fund more effective at capturing short-term moves, but it reduces the long-term efficiency. In contrast, the Teucrium WTI Crude Oil Fund (NYSEARCA:CRUD) spreads its investments evenly across three different maturities and rolls only four times a year – reducing the impact of contango and backwardation, but also reducing the correlation to spot prices.

It is also important to note the difference between ETFs and exchange traded notes (ETNs) like the iPath S&P GSCI Crude Oil Total Return Index ETN (NYSEARCA:OIL). ETNs are unsecured debt securities issued by an underwriting bank and basically represent a promise on the part of the bank to pay the returns of the stated index (minus fees). ETNs can offer better tax efficiency and less tracking error, but they offer credit risk that isn’t present with ETFs.

The Names To Know

As mentioned, U.S. Oil Fund is the largest and most liquid oil ETF trading on U.S. exchanges. USO uses futures, options, and forward contracts to track NYMEX oil futures, and focuses on front-month contracts. The expense ratio here is relatively low at 0.45%, while assets under management ($1.28 billion) and average volume (10.7 million) are quite high.

The PowerShares DB Oil Fund (NYSEARCA:DBO) is the second-largest pure oil fund in terms of assets under management. Less than half the size of USO ($602 million under management) and much less liquid (average volume of about 521,000 shares a day), DBO offers a similar expense ratio (0.50%). Like USO, DBO’s returns are more closely correlated with spot oil price performance.

As mentioned before, the Teucrium WTI Crude Oil Fund takes a different approach to its portfolio – reducing costs by rolling over contracts only four times a year. Unfortunately, this approach has not proven especially popular with the market just yet. CRUD has an AUM of just $2 million and a tiny volume of just over 500 shares per day. Due in part to the inefficiencies of scale here, the expense ratio is high at 1.54% [see also The Different Types of Brent Oil Futures Compared].

The iPath S&P GSCI Crude Oil Total Return Index ETN is the largest oil-related ETN on the market. The returns for OIL include a Treasury bill rate of interest on funds committed, which admittedly does not amount to much in today’s low-rate environment. Expenses fall toward the higher end at 0.75%, and the AUM sits at approximately $450 million. Daily average volume is a healthy 840,000, though.

Last and not least is the U.S. 12-Month Oil ETF (NYSEARCA:USL). USL invests equal amounts of money in the next 12 consecutive months of WTI NYMEX oil futures contracts, giving investors an even exposure to near-term and intermediate-term oil prices. This ETF is rather small with an AUM of $127 million and volume of just 33,000 shares, but the expense ratio of 0.60% is not unreasonable.

The United States Brent Oil Fund (NYSEARCA:BNO) is one of the very few available plays on Brent crude oil futures trading on the ICE Futures Exchange. BNO is small ($47 million in AUM), but reasonably liquid (48,000 shares per day). The expense ratio of 0.75% is on the higher end of the scale, and the fund’s holdings on concentrated on front-month contracts.

Alternatives Worth Knowing

While the aforementioned ETFs and ETN are relatively “vanilla,” there are some riskier alternatives for investors and traders to consider.

The U.S. Short Oil Fund (NYSEARCA:DNO) is designed to deliver the inverse return of the front-month WTI crude oil contract. This is a very small fund (only about $8 million in AUM), but the PowerShares DB Crude Oil Short ETN (NYSEARCA:SZO) is scarcely larger at $15 million in AUM. Nevertheless, they do offer a way to play falling oil prices outside of shorting shares like USO (and paying the borrowing costs).

Investors looking for even more risk and volatility can consider the leveraged ETFs. ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO) offers daily returns of 2x the Dow Jones-UBS Crude Oil sub-index, while PowerShares DB Crude Oil Double Short ETN (NYSEARCA:DTO) offers double leverage in the opposite direction, as does the ProShares UltraShort DJ-UBS Crude Oil (NYSEARCA:SCO) ETF, though DTO also includes a T-bill return component. These highly leveraged funds are much larger in terms of AUM and average trading volume, but investors and traders should understand that they’re not intended as long-term vehicles – not only are they not especially tax-efficient, but the daily re-balancing of some of these funds creates meaningful volatility drag. Note that PowerShares’ products, such as DTO, use a monthly reset to minimize volatility drag, but it is still a fund designed for active traders and investors nevertheless.

The Bottom Line

ETFs and ETNs offer investors a wealth of choices for executing their particular vision and outlook for crude oil prices. What’s more, they offer investors considerable convenience when it comes to margins, commissions, and tax reporting compared with similar futures positions. Though investors pay for this convenience in the form of fund expenses, oil ETFs are a valid and practical way for traders to add crude exposure to their portfolios or execute crude-focused trading strategies.

Disclosure: No positions at time of writing.

Disclaimer: Commodity HQ is not an investment advisor, and any content published by Commodity HQ does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities or investment assets. Read the full disclaimer here

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Source: The 5-Minute Guide To Oil ETFs