Light and Sweet: Oil ETFs Ranked

Assessing oil ETFs is not a standard exercise. These ETFs target crude oil, not oil companies, so P/E ratios and average holding size are irrelevant metrics. We use other methods to pick favorites among the big crude oil players. We also find some useful niche funds for specialty situations.

How do oil ETFs get their crude? Not by buying it at day-to-day spot prices. One-month futures contracts for West Texas Intermediate (or light, sweet crude) are currently the holding of choice for these funds. Their returns over the past year follow:

iPath S&P GSCI Crude Oil Total Return ETN (OIL) and United States Oil Fund (USO) run neck and neck so as to be practically impossible to tell apart. Invesco PowerShares DB Oil ETF (DBO) has lagged noticeably.

While spot prices are easy to follow in the news, they are hard to build a fund around. Large oil producers and users trade oil at spot prices at the New York Merc, but pricing swings can be enormous. Any fund trying to maintain accurate exposure to spot prices permanently would have to buy and sell them constantly. The cost would be prohibitive.

Another method is to take delivery of actual oil, buy some tanks and hold physical inventory. This is done with gold, and a few hedge fund managers do this with oil, but they do not have to unwind the arrangement at the snap of an investor's finger like an ETF. Oil is not as compact as gold. Judging by the fact that no ETFs use spot pricing or physical possession, it's a good bet that these are not desirable methods of creating ETF shares.

As one might imagine, returns for oil bought now but received weeks away can deliver substantially different returns than from instantaneous spot prices, especially when prices gyrate such as in today's topsy-turvy market. There have been complaints by pundits and investors about oil ETFs' poor tracking of spot prices, but a simple deviation here and there is to be expected. Oil ETFs may not track their target perfectly, but they do so with the best available tool. It should be remembered that quoted spot prices generally don't include fees, whereas ETF performance includes futures transaction costs. Futures require cash deposits of about 5-10 of the value of the contracts, so in practice ETFs deposit short-term Treasuries with brokerage firms and earn minor interest.

Competition in playing the futures-buying game is an obvious way for a fund to differentiate itself. OIL "rolls over" its contracts by methodically selling contracts it holds five days before expiration date nears and buying new contracts due in one month. USO grants wide latitude to its managers to handle roll but apparently adopts a similar strategy to OIL.

DBO, however, is a slightly different animal. It has a sophisticated strategy called Optimum Yield to improve the results of roll. This proprietary formula tries to dampen contango, or losses when a next-to-expire contract is trading at a lower price than contracts expiring in later months, and to maximize backwardation, when the next-to-expire contract is trading at a higher price than contracts expiring in later months. Judging from the past year's results, however, the sophisticated strategy is backfiring. DBO managers would have been better off with a computer rolling over the contracts on a preset schedule.

Based on returns so far, USO and OIL are the obvious top picks for a straight oil ETF. Of the two, we further recommend USO because of very fair fees of .50% per year, one third less than OIL. As in those few broad market categories where multiple ETFs track exactly the same index, here the indexes appear nearly identical. We see no reason to buy anything but USO.

A final note on the benchmark. West Texas Intermediate is a standard built around typical US-produced oil, so it is controlled, as much as oil can be, by Americans. But WTI, and indeed all "sweet" or low-sulfur crude oils, are being displaced by "sour" versions from the Middle East and Russia. Thus WTI no longer represents global crude pricing well, and it is subject to distortions simply because fewer and fewer transport and refinery facilities are devoted to it.

There are some niche ETFs as well. USO's parent company also offers two other petroleum market ETFs: United States 12 Month Oil (USL) and United States Heating Oil (UHN). USL carries futures contracts for 12 upcoming months in equal measure, so it will deliver much smoother returns on average. It clearly is not useful to the investor who expects a jump in prices fairly soon, but for long-term exposure with reduced volatility it makes lots of sense. At .66% in annual fees, USL fees seem fair but not a bargain. UHN, meanwhile, is for the investor who follows cold weather to judge the heating needs of the East Coast where heating oil is so often used. Western states uses natural gas.

Finally, there are several leveraged funds: ProShares Ultra Oil & Gas ETF (DIG) and ProShares UltraShort Oil & Gas ETF (DUG). Needless to say, they are volatile and suitable for only the careful trader, and even then only in appropriate amounts. DIG attempts to deliver on twice the daily return of the Dow Jones Oil and Gas Index while DUG delivers twice the daily inverse or a double short of that index.

Comments

[Lee Borden]

Thanks for a rare gift, a frank and factual discussion of the differences among the various oil-related ETFs. It's refreshing to find such useful information in the normal thicket of shrill conclusions about what's going to happen in all of this.

I know your focus is ETFs rather than investment in crude oil, but could I interest you in an assignment? With all the proposals floating in Congress now to "stamp out speculation," what effect will these various proposals have, if any, on the ability of USO and OIL to continue their core investment strategy?

I think Congress is being somewhat sloppy with its terminology, using "speculation"... and "manipulation&quo... more or less interchangeably. If Congress acts to counter manipulation, it would be doing a service to the investment community. If it acts to reduce speculation, however, my assumption is that it will succeed only in moving oil speculation to other countries. It may then be harder or impossible for U.S. investors to speculate, but the speculation will nevertheless occur. Do you have any thoughts on this?

[Will McClatchy at ETFzone.com]

Dear Lee,

There is a recent surge in speculation, no doubt about it, and at least temporarily that has to have impacted prices. Long-term it should stimulate production of all types of energy and not affect prices so dramatically. I suspect that the big institutional funds serving pension plans will simply go to London and trade Brent Sea crude or Middle Eastern varieties, and these funds represent the lion's share of the financial buyers (not oil industry players) in the market. Smaller amounts of capital in the hands of individual investors may be dissuaded. USO and OIL use wait until the regulators come knocking on the door but they are simply long at all times. I am having a hard time picturing how regulators could put the ETFs out of business without yanking many, many other players with vast amounts of capital out of the futures markets. Seems unlikely to me. Hope that helps.

-Will McClatchy

[sbenard]

You forgot some of the best oil ETFs in the stable. Deutsche Bank has some new ones to short the crude oil market also. These have grown by leaps and bounds. Check out DXO, DTO, SZO, and OLO. There are others, also.

[sbenard]

Lee, I have written about the consequences of Congressional meddling in the financial markets on my own blog. Some consequences include:

1) Capital flight. This will further collapse the Dollar and hasten the movement away from the USD as the world's primary reserve currency. It will also cause greater inflation
2) Commodities will go to countries that are willing to pay for them. This will cause shortages in the U.S. as politicians resort to more and more strong-arm tactics to reign in inflation.
3) The super rich, instead of buying the futures, will simply use their wealth to buy the assets that produce the commodities instead. Instead of buying oil or grain futures, they'll buy the land on which they are grown or from which they are extracted, instead. Same with metals; they'll buy the mines. In rapidly higher inflation, its easy to buy the oil well and just sit on it, waiting for prices to rise.

Study Hugo Chavez' methods in Venezuela. The U.S. Congress isn't that far behind Chavez in their methods -- or in the results they'll obtain. Hyperinflation, plunging production, shortages!

[sbenard]

One last thing:

There are other futures exchanges growing around the world that traders will start to use, if the U.S. Congress becomes too burdensome. Here is an article about a few:

globalcapital.blogspot...