What To Do With Oil?

Includes: BNO, USO
by: Jeroen Blokland


Historically, the oil price is characterized by a strong seasonality effect. The price returns in the last three months of the year have been dismal on average.

Also, compared to a broad commodity index, oil prices tend to lag significantly in the second half of the year, with the last three months being the cruelest.

In addition, investors in oil ETFs like BNO and USO should take into account the oil futures curve is currently in contango, resulting in a negative roll return.

Strong seasonality and the negative roll returns are of importance for an oil investment and should, especially in the case of low conviction, be part of the decision making process.

Oil is giving investors headaches. Since the middle of this year the Exchange Traded Funds invest in Brent oil (NYSEARCA:BNO) and WTI crude oil (NYSEARCA:USO) followed the commodity in its 30% slide. In the last couple of weeks the pressure increased, pushing the price of a barrel of Brent oil briefly below USD 82, before rebounding marginally. This raises the question, now that we have reached a multi-year low, what to do with oil?

Break-even issues

Recently, The Economist posted an insightful article discussing the winners and losers of lower oil prices (read here). In a very telling graph it showed that for most of the major oil producing countries, the oil price has fallen below the break-even price needed to keep the government budgets of these countries in positive territory. These countries include, among others, Iran, Iraq, Nigeria, Russia, Venezuela, and the world's king of oil, Saudi Arabia. Since the publication of the article by The Economist, on October 25th, the price of crude oil went down again, worsening the outlook for oil producing countries.

On top of that, analysts estimate that more than half of the US shale projects are no longer profitable at the current oil price. Many of these analysts expect that because of the increasing number of countries and companies have to deal with below break-even oil prices, the low is near. And with the upcoming OPEC meeting this month this could indeed well be the case.

Major Seasonality

But before you invest all of your money in barrels of oil, I would like to point out a couple of things. First, just like with equities, oil prices are characterized by strong seasonal effects. The chart below shows the average return per calendar month for Brent oil, starting in 1991. As the chart neatly demonstrates, the fourth quarter of the year is pretty miserable for oil prices. And January is not that great either. In case of WTI crude oil, the results are similar, although the average return in December is close to zero.

Splitting up each year in the first and the second half reveals a major seasonality effect in oil prices. Since 1991, investing in oil only in the first six months of the year would have resulted in an average price return of almost 12%. An investment in oil in the second half of the year, on the other hand, would have cost you 1.7%. If we take a more recent period, starting in 2002 (the characteristics of commodity markets and their role as an investment class has changed quite a bit over the last decade), the return differential between the first and the second half of the year is even more pronounced. Unless you have a very strong conviction that oil prices must have bottomed right now, you might want to take this seasonality numbers into account.

Now, everything is relative, right? The return data in the charts above represent that of an oil investment on a stand-alone basis. Multi asset mutual funds, endowment funds, pension funds, and perhaps you as well, might opt for an oil investment instead of a broader commodity index as a tactical decision to get exposure to this asset class. So, what would the investment case be then focusing again on historical calendar month return data. The chart below reveals that oil price returns relative to the returns on the Bloomberg commodity index show a similar seasonal pattern. Historically, oil has underperformed the general commodity index in October, November and December.

And, similar to the return results of oil on a stand-alone basis, the relative return in the first half of the year (+10%) is massively better than the relative return of oil in the second half of the year (-2.0%). Again, the results are even stronger for the shorter period starting in 2002. The second half of the year, but especially the last three months of the year, in which we are now, have been outright dismal for oil investments.


So far I have looked at price returns only. Unfortunately, many of us do not have the resources to buy and store physical barrels of oil. This is where ETF's like BNO and USO come in. These exchange traded funds invest in oil futures to get exposure to Brent and crude WTI oil. An investment in these ETF's automatically involves exposure to the oil futures curve as well. This is what the futures curve looks right now for Brent oil (again the WTI Crude oil data is similar, though less extreme).

As can be derived from the graph the curve is upward sloping, hence in contango. This implies that you buy the oil future at a higher price than the current spot price. Now, there are quite a few possible explanations of why this is (which are outside the scope of this article), but an important thing to keep in mind is that, if everything stays the same, the future price will roll down the curve towards the spot price. That will result in a negative roll return. Only, when the spot price moves up to meet the futures price (or even higher) your roll return will be zero (positive).

The slope of the futures curve is an important aspect to keep in mind when using oil ETFs that invest in futures. Suppose you expect the Brent oil price to rebound to USD 90. And let's suppose that you are right, but also that the rebound does not in the first six months from now. In the case that (the shape of) the futures curve does not move at all, you will currently lose an average of 0.8% negative roll return per month! This sounds theoretical, but it's not. In the last four months the shape of the curve has stayed pretty much the same, with contango resulting in a negative roll return in each of these four months. On top of that the entire futures curve came down with the crash in oil prices, causing a double whammy for investors. Just look at the total return (spot and roll return) data on Brent oil over the last four months.

To summarize; historically, the last two months of the year have been very ugly for the oil price. The first six months of the year has traditionally been the best period to investment in oil. For those who are considering such an investment to could be something to keep in mind. Second, for some time now, the oil futures curve has been in contango, with negative roll returns as a result. This implies that even if your prediction of a rebound in oil prices proves to be right, you could still lose money. The longer the price increase takes the more negative roll return you have to accept.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here