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DBO: Prepare For More Upside In Crude Oil

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About: Invesco DB Oil ETF (DBO)
by: QuandaryFX
QuandaryFX
Short-term horizon, currencies, commodities, long/short equity
Summary

DBO’s methodology is currently shining as crude structure is veering towards contango in the front of the curve.

Given that backwardation is present in the later months of the curve, DBO is poised to give positive roll yield while competitive funds lag.

Crude markets are bullish due to key supply risks remaining throughout 2020.

With shares delivering nearly 9% over the last 3 months, the Invesco DB Oil ETF (DBO) has given solid performance for holders of the fund. In this piece, I will argue that given the recent changes in the structure of WTI futures, an investment in DBO is bound to outperform more popular alternatives and that shareholders are likely to see positive returns in the ETF throughout 2020.

It’s DBO’s Time to Shine

If you’re familiar with oil market ETPs, you’re likely aware that there are a lot of them. There is a broad variety of oil ETNs and ETFs which provide a whole gamut of methods of tracking WTI and Brent futures. DBO is one of my favorite ETFs in the lineup of available funds in that it tackles a very big issue head-on and seeks to give long traders in the fund strong returns. I’m talking, of course, about roll yield.

If you’ve invested in commodity ETFs or ETNs before, you’ve likely encountered the issue of roll yield in the prospectus or methodology to some extent or another. The reason why this is the case is that in some situations, roll yield can be one of the primary drivers of returns in an instrument. For example, the BNO ETF (which tracks Brent crude) delivered around 15% return to investors purely based on roll yield in 2019. In other words, if you held BNO last year, you would have outperformed the outright price of Brent oil by around 15% simply due to roll yield.

Roll yield is what happens when you hold exposure across a futures curve in a month beyond the front-month contract. The basic idea behind roll yield is that “futures converge to the spot”. In other words, as time progresses, you tend to see futures prices at the back of the curve move towards the front of the curve. Depending on the structure (prices of specific futures months in relation to each other) of the curve, roll yield will be either positive or negative.

To graphically understand this, here’s the current WTI futures curve.

It was a bit of an unusual day in that the February contract settled at exactly the same price as March, but for the past few days we’ve seen March price under February (backwardation). When a market is in backwardation, if you are holding a long position in the back contract, you tend to see positive roll yield because your futures contracts will be trading up in value in an approach towards the spot.

At present, the market is currently seeing the front of the curve collapse towards contango. Specifically, over the last few trading sessions, we have seen the front two contracts narrow by around $0.20 per barrel, and at the current trajectory, we will be in contango within a few trading sessions. And here’s where DBO’s methodology starts to shine.

If you’re familiar with oil market ETPs, you’re likely aware of the United States Oil ETF (USO). USO is the granddaddy of the trading oil funds in that it has one of the largest market caps out in the industry, as well as is one of the first movers in the space. USO has a very simple methodology: two weeks before expiry, it rolls exposure into the second-month futures contract and then holds until repeating the process the next month. The problem here is that the front two WTI contracts are generally in contango, which means that USO is normally losing from negative roll yield.

The brilliance of DBO is this: it adaptively shifts exposure across the futures curve. In other words, if you read its methodology, you will see that it seeks to provide the most optimum roll yield to investors using the DBIQ approach created by Deutsche Bank.

How DBO accomplishes this is that it shifts exposure into later-month futures contracts when it comes time to roll such that it maximizes backwardation or minimizes contango. In other words, when the curve is backward, it tends to be holding later-month futures contracts to maximize the positive roll. When it last rolled, it rolled into February futures, but given the contango which is rapidly creeping into the front of the curve, we will likely see DBO shift exposure into later months (probably April or May based on historic rolls).

When DBO shifts its exposure (within the next few days), this will mean it is once again delivering positive roll yield (because it is shifting exposure further back on a backwardated curve), whereas more popular ETFs like USO will be delivery losses from the roll due to its simplistic methodology. In other words, if you’re looking for exposure to oil, DBO is a choice option at this time based on its delivery of solid roll yield.

Crude Markets

I spent a good breadth of space talking about the finer points of DBO because, let’s face it: if you’re reading an article about DBO, you probably already have a view on oil markets and are looking to allocate capital to the best ETF or ETN out there. I believe DBO is premier based on its rolling strategy and represents a good investment.

However, it is my belief that in general we are going to see the price of oil increase. In rapid-fire order, let’s march through the key fundamentals.

First off, crude stocks have started the year off with inventories right at the 5-year average, with 2019 ending on a weak note.

We have seen the year-over-year change in inventories shrink into the negative territory for the first time in several quarters.

The key drivers here are, first off, production growth: it is slowing.

And second, imports remain very low, with almost every week of 2019 setting the low of the 5-year range.

These two issues represent serious supply risk to the balance going forward. First off, production growth is slowing due to bankruptcies in the Permian. The story here is that capital constraints due to poor cash flows have resulted in operators going bankrupt - this trend is going to continue until prices rise, because the price of crude is the primary source of revenue for these firms. In other words, the trend in price is going to keep increasing until the pain stops, or else more pain will drive the price higher.

And secondly, OPEC cuts will be an issue through 2020 with OPEC complying with its strict cuts. These cuts resulted in a collapse in imports into the United States, and this will continue for at least the next 3 months - again, another trend which will only be corrected through higher prices. OPEC has a direct interest in higher oil prices, and if it doesn’t get the price of oil to its desired level, it will continue or extend the cuts to get the price where it desires.

These twin fundamentals strongly suggest that 2020 will see tighter crude supplies and prices which will generally rise throughout the year. It’s a great time to buy DBO.

Conclusion

DBO’s methodology is currently shining as crude structure is veering towards contango in the front of the curve. Given that backwardation is present in the later months of the curve, DBO is poised to give positive roll yield while competitive funds lag. Crude markets are bullish due to key supply risks remaining throughout 2020.

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.