If you’ve been investing in the iPath S&P Crude Oil Total Return Index ETN (OIL) for any length of time, you’re aware of one thing: it’s volatile. Since the beginning of the year, shareholders in the ETN have seen a gain of over 20% in a relentless rally. However, if you were unlucky enough to have bought the highs of last year, you have unfortunately experienced a decline of 26% in the value of your holdings.
When we are evaluating an ETN and considering how to trade it, we need to first understand its methodology. Often, the devil is in the details for many financial products and OIL is no different. In the following minutes, I’ll dig into the mechanics of the OIL ETN as well as provide a fundamental assessment of the underlying instruments it seeks to track. If you’re busy and pushed for time and want to jump straight to the conclusion, I think OIL is a bad investment at this time and investors should sell or considering shorting the security based both on its mechanics and fundamentals.
First, let’s dig into the prospectus of OIL to see how it works. The OIL ETN seeks to track the S&P Crude Oil index. What does this mean? Well, for one, it means that OIL is basically a proxy instrument – when you hold it, you’re basically holding exposure to the S&P Crude Oil index – so if you want to understand why you made or lost money in a given time period, you need to understand what exactly the S&P Crude Oil index did and why.
The objective of the S&P Crude Oil index is to give an investable return of WTI futures contracts. If you’re unfamiliar with the index, the most important thing to know from an investing standpoint is the answer to the question: “How do you roll?” When you buy an ETN or ETF which tracks the commodities markets, you have an interesting problem known as “roll yield”. The basic idea is this – if you want to hold an investment in the futures market for long periods of time you either have to buy a contract long enough into the future that it won’t expire while you hold it or you must roll your position into the next month by simultaneously exiting a position in one month and entering the same position in a later month. The problem with this strategy is that in general, futures contracts tend to converge to the front-month price. In other words, all else equal, as you approach expiry of a futures contract, the contracts in later months tend to slide towards the prompt price. When the market is in contango (front contracts trading under back contracts), prices in later months generally fall on a relative basis as they approach prompt.
For investors in OIL, this is where the things get relevant. Since the S&P Crude Oil index is required to roll positions to maintain exposure to WTI futures, when the market is in contango, it will be losing on the roll yield. When it is in backwardation, it will be gaining versus futures. In the following chart, I have captured this relationship to show the existence of it in the data.
This chart shows the return of an investment in both OIL and front month WTI futures through time. The filled area chart is the structure of the WTI markets – when it is negative, the market is in contango and OIL will be lagging the performance of futures. When it is positive, the market is in backwardation and OIL will be gaining versus futures. You can see this relationship played out more strongly in this differential chart which takes the same data as in the chart above, but nets the cumulative return between OIL and prompt WTI futures.
As you can see – when the market is in contango, OIL’s return lags versus the benchmark it’s trying to track due to negative roll yield. When the market is in backwardation, OIL is gaining versus its benchmark.
Given that we know the market is in contango, we know that in general, an investment in OIL will experience constant erosion in performance while we remain in this regime. But this is only half of the picture. To generate a full investment thesis, we need to dig into the fundamentals of what it tracks: WTI.
When we evaluate fundamentals of a commodity, it’s always a great place to start by looking at the supply and demand balance as expressed through the total inventory level in a 5-year range chart.
Despite the strong blip two weeks ago, crude stocks remain elevated. With inventories trading over their 5-year average, the market is simply oversupplied. The main driver here of course is production – which has continued to surge to new highs.
This production ideally would be chewed up by refineries producing gasoline and distillate to flood the markets, but the gasoline market is already oversupplied (and gasoline is almost half of what is produced by refineries).
With the gasoline market oversupplied, refineries hurt themselves through strong runs in the first two months of this year.
These strong runs essentially crushed the gas cracks around the country with some benchmarks reaching multi-year lows.
Given the situation of an oversupplied product market and strong production, the only source of demand is exports – which have been very strong.
Exports are largely dependent on and correlated with the Brent-WTI spread. As inventories continue to rise, I would expect to see the Brent-WTI spread continue to widen and exports continue to brush up against their capacity.
As you can see, the basic fundamental picture in the crude markets is that crude is oversupplied. Refineries have room to run more crude, but economics will need to improve first (which will likely happen in two months when driving season kicks off). In the meanwhile, the only other balancing mechanism on the supply side is a decrease in imports – which has been happening as refining runs have slowed.
The saving grace of the petroleum markets right now is a decrease in imports coupled with an increase in exports. The key question for the markets is this: can this trend remain? If we can continue to see growing exports and weakening imports, we have a chance of seeing balance return to the market. Until then however, the basic catalyst remains. Crude oil is oversupplied and there isn’t much room on the product side to absorb it. When crude is oversupplied, it goes into inventories. And as you can see in the following chart which compares crude stocks to its 5-year average: when crude stocks are rising on a relative basis, market structure is weak.
Given the current bearish fundamental thesis, I would suggest shorting crude oil until balance returns to the market. I would time that balance as the level of inventories moving under their 5-year average. I believe this might happen during the summer driving season, but until then, bearishness is the theme of the day. Given this environment, I suggest shorting or exiting positions in OIL. Not only are the fundamentals bearish, but as you can see in the above chart, the direction of inventories is directly correlated with the structure in the futures market. When the inventories are strong against their 5-year average (as they are now), the market tends to trade in contango. And as we previously discussed, a market in contango is bad for the index which OIL tracks and therefore bad for the holders of OIL. Given these fundamentals I would suggest avoiding the OIL ETN for the time being.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.