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BNO: Take The OPEC Trade

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About: United States Brent Oil Fund, LP (BNO)
by: QuandaryFX
Summary

BNO offers exposure to Brent futures contracts which are in backwardation and therefore providing strong roll yield.

Brent is a waterborne barrel, which means that it is directly competitive with OPEC barrels.

Given OPEC’s ongoing cuts and the extension through March 2020, I expect Brent crude oil to continue trading up through the early part of next year.

Friday was a great day for the United States Brent Oil Fund (BNO), with shares of the fund delivery nearly 4% in a single session, bringing the year-to-date total gain to nearly 24%. As I will argue in the following article, I believe that we are slated to see higher prices for crude oil over the next year and that the price of BNO will continue to increase.

Understanding BNO

BNO is an interesting product in the oil market ETP space in that it offers direct exposure to Brent futures. If you’re familiar with the lineup of oil market funds, almost every single one is exclusively WTI or a mix of WTI and Brent through an instrument which follows the GSCI methodology. By offering exposure to Brent crude oil, BNO gives the opportunity for investors to capture a slightly different package of fundamental drivers than those impacting WTI futures based on the location of the Brent contract.

Brent is a waterborne grade of crude which is produced in the North Sea. It is a very interesting crude in that it essentially comes straight out of the ground and has immediate access to any location in the world through shipment. WTI, on the other hand, is a grade of crude priced in the middle of North America, and it must travel through pipeline and be put on a ship before it is able to be a directly comparable or competitive grade to Brent oil. This means that if you’re trading Brent, you’re trading something different than WTI by a few steps.

However, an important caveat to this belief is to understand that Brent and WTI are highly correlated, and even though they represent two different grades of the crude, their price movements will move in concert for the most part. To help understand this, in the following chart I have shown the price differential between these two crudes.

As you can see, since crude exports were legalized in the United States in early 2016, Brent and WTI have traded a few dollars apart from each other, with price fluctuations playing out over movements which last several months. In other words, the instruments are highly correlated. To numerically frame it up, weekly movements of Brent and WTI have been 90% correlated over the last year - as goes one, so goes the other.

This aside, if you are trading BNO, you are favored versus trading a WTI-based product in that you currently have positive roll yield. As you can see in the Brent futures curve, the market is in over $0.67 per barrel of backwardation in the front two months. BNO is currently holding January Brent futures, as can be seen in the following table of holdings.

However, two weeks before expiry, BNO will shift exposure into February futures as detailed in its prospectus. This means that roll yield will be positive for the ETF because holdings will be at a lower-priced contract due to the backwardation in the curve, and the general principle of roll yield is that as time progresses, back-month contracts trade towards the front. As February futures trade up towards January, BNO will see positive returns from roll yield, which will be a tailwind for holdings of the ETF.

Market Factors

In and of itself, roll yield in Brent futures can be a strong reason for holding BNO. Roll yield typically turns positive when a market is fundamentally short a commodity, and therefore, is generally associated with prices which are trending higher. However, roll yield can also deliver positive returns even if the price of crude goes nowhere, because the exposure in the back month will price up in relation to the front until the front expires. All this said, I believe that the fundamental situation impacting Brent provides a strong catalyst for price appreciation in the coming weeks.

The first variable to understand when it comes to Brent is that it is a waterborne barrel of crude oil which is similar in specifications to many OPEC barrels. This means that it is a directly competitive barrel to OPEC volumes. At the beginning of 2019, OPEC initiated production cuts which limited the amount of barrels that it would produce and sell to other countries. In the middle of 2019, it agreed to extend these cuts through March 2020.

Good quality oil market fundamental data is hard to come by in most countries besides the United States, but the same picture of very weak imports seen in the United States has almost certainly been seen in all other countries which import OPEC barrels.

What this tangibly means is that since the globe is short OPEC barrels, it will be pulling on Brent barrels to fill in the void. Brent production is relatively stable (and generally declining) through time, which means that an uptick in demand directly results in an uptick in price. For example, since OPEC cuts were initiated in January of this year, the price of BNO has rallied by nearly 24%.

Since nothing fundamental has changed and the cuts which directly affect the Brent-competitor barrel are going to remain for the next 5 months, it is entirely reasonable to believe that a similar trend in the price of crude oil could be seen going forward. As long as OPEC cuts remain, the price of Brent will generally be increasing in value due to heightened demand for Brent oil. Based on this reason, I believe holding Brent is a solid trade until OPEC cuts end on the first of April. It’s a great day to buy BNO.

Conclusion

BNO offers exposure to Brent futures contracts which are in backwardation and therefore providing strong roll yield. Brent is a waterborne barrel, which means that it is directly competitive with OPEC barrels. Given OPEC’s ongoing cuts and the extension through March 2020, I expect Brent crude oil to continue trading up through the early part of next year.

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.