For investors in the Brent Oil Fund (BNO), these last few months have been anything but peaceful. With the ETF falling over 33% before rallying 20% since the beginning of the year, investors have experienced great volatility in the instrument. In this article, I would like to dig into the mechanics of the Brent fund as well as some of the global fundamentals impacting the instrument. If you’re pressed for time, then I’ll jump straight to the conclusion: on an outright basis, I would suggest shorting Brent, but a Brent / WTI (USO) trade looks very attractive at this time.
If you’ve ever examined the prospectus for BNO, you’ll find that it’s basically a sister ETF to the more popular WTI tracking ETF, USO. Each fund has a very similar methodology and follows the same rolling procedure. If you’re unfamiliar with this rolling procedure, the most important thing to be aware of is the concept of “roll yield”.
When you invest in futures markets on a long-term basis, you are required to roll your positions from one month to another month when the market nears expiry. This process exposes you to an interesting feature of the future market which is that as futures near expiry, in general, each contract slowly moves towards prompt price. If you have a position spread across two months (as BNO and USO do during the roll window), then you will experience either a slight drag or gain on performance based on the shape of market structure. When the market is in contango (as is WTI), then holdings in the back months lose versus front months as they trade down towards prompt. If the market is in backwardation (as is Brent), then holdings in the back months gain as they rise in value towards the prompt month as expiry nears. This structural feature is responsible for substantial differences in performance between the underlying futures contracts and the ETFs which seek to track them.
In the case of Brent, the market has been caught in backwardation. Brent is essentially the global benchmark of waterborne light sweet crude and any disruptions to global supply will reflect into the term structure of the market. In December, OPEC and friends agreed to cut their output by 1.2 MMBD. These cuts ultimately impact a number of different countries, but given that Brent is a free-trading benchmark barrel, the market responded with a switch to backwardation as a physically-constrained market in the prompt led to front barrels being bid-up versus future barrels.
If we were simply trading market structure, then buying Brent and the BNO ETF would be a pretty simple call: do it. But, the global markets are much more interconnected. Even though local crude disruptions can impact individual pricing benchmarks the overall market moves together like the ocean level. And the primary driver of these movements is WTI.
The WTI market has been caught in a state of oversupply for several years. As seen in the following chart, the weekly inventory statistic has been reported as over its 5-year average in almost every month of the last decade.
This oversupply situation has resulted in the WTI market being caught in contango for most years in recent history.
When the market is in contango, it is signaling immediate oversupply in relation to months further out. This oversupplied situation has resulted in WTI prices widening versus Brent (its global waterborne alternative).
With a widening Brent-WTI spread, we have seen exports from the United States rise to previously unimagined levels.
These exports are comprised of a variety of crude types but in general, exports from the United States can serve to replace or even compete with the BFOE grades constituting the Brent stream.
Given the state of United States’ exports and the price-leading nature of WTI futures, I am outright bearish on Brent and the BNO ETF. There is a direct correlation between U.S. inventory changes and crude price movements and a direct lockstep-correlation between WTI prices and Brent.
So from a fundamental nature, you can easily say, “as goes WTI, so goes the world.” However, when it comes to the Brent ETF BNO, the instrument is directly exposed to a positive roll yield. This positive roll yield situation comes from the backwardation present in the market and it will likely remain this way until OPEC ceases its cuts. And there’s a good chance that OPEC will not do this until they have achieved an internal (higher) price target. Without speculating on that price target and what they are seeking to accomplish, we can safely explore a statistically-backed trade: trade the Brent-WTI spread.
In particular, what I propose is not an outright position in Brent or WTI futures, but a trade in which we buy the BNO ETF but sell the USO ETF to capture both the price movement differentials and the roll yield situations. USO is experiencing a negative roll yield (and has been doing so for a long time) due to its tendency towards contango for structural reasons. BNO is experiencing positive roll yield due to its global waterborne status and direct impact from OPEC sanctions. A trade buying BNO and shorting USO for as long as these catalysts exist will result in a constant and gradual double benefit from shorting a negative roll and buying a positive roll.
This strategy will require you to periodically rebalance your holdings to maintain exposure to the relationship in equal quantities, but simple tests of it show a positive and consistent history of profit earned. For example, here is the historic percent return gained from using the strategy since the weeks leading up to the recent changes in fundamentals.
This is the performance you would have earned if you would have rebalanced your holdings daily by keeping a perfect equal dollar exposure on both the long and short side. Since the weeks leading up to the pop in oil, this strategy has returned about 8%. This strategy both captures the widening Brent-WTI spread, but it also benefits from purchasing an instrument exposed to positive roll and shorting an instrument exposed to negative roll.
As long as the current fundamental situation remains, outright buying anything exposed to crude oil is probably a bad trade. However, if we dig into the relationships and mechanics of the instruments we track, we can find profitable opportunities, even in a sea of bearishness. As long as OPEC cuts remain and the United States remains oversupplied, buying BNO and shorting USO remains a good trade.
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.