Why This Oil ETF Could Do Better Than Crude

When it comes to investing in energy, oil ETF shares haven't delivered very good returns historically. But more recently, a somewhat unusual phenomenon in the oil futures markets could make oil ETF prices deliver better returns than the spot price of crude.

Why futures matter for oil ETFs
The name of that phenomenon is backwardation, and the reason it's important has to do with the strategy that the typical oil ETF uses to track crude prices. Many commodity ETFs, such as iShares Silver Trust (NYSEMKT: SLV  ) and SPDR Gold (NYSEMKT: GLD  ) , actually buy the underlying physical commodity, storing it in a vault for safekeeping and thereby connecting the value of the ETF share to an actual portion of the ETF's commodity holdings.

For oil ETFs, however, holding actual crude would be expensive and impractical. Therefore, most ETFs buy oil futures contracts to track changing prices.

Using futures can cause problems, however, when expectations of future spot prices differ from current prices. In particular, oil markets have spent most of the past several years in what's known as contango, which means that expectations were for spot prices to rise. In simplest terms, contango meant that the oil ETF United States Oil Fund (NYSEMKT: USO  ) had to replace lower-priced expiring futures contracts with new higher-priced futures every month, sapping the ETF's long-term returns. That's the key reason that shares of the ETF have fallen by two-thirds in the past five years, even as oil prices have only declined by about 25% over the same timespan.

Contango gives way to backwardation
Now, though, those trends are starting to change. Contango's opposite is backwardation, and it should be a benefit for any oil ETF that uses a futures-based strategy.

Futures markets now predict falling spot crude oil prices in the future. For West Texas Intermediate, backwardation doesn't start appearing until you compare the July contract with future-month contracts, but starting then, expectations are for the July price of $88 to drop to $86.30 by this December and to just over $80 by 2020. For Brent crude futures, backwardation starts almost immediately, with the June contract's price near $100 declining to below $99 by this December and to below $90 by 2019.

How to invest
If those trends persist, then it could eventually solve the problem that United States Oil Fund has had in underperforming the spot price of crude. Given Brent's stronger backwardation trend, United States Brent Oil Fund (NYSEMKT: BNO  ) might be the better oil ETF to choose.

Another choice is to use ETFs with a longer-term futures strategy. The United States 12-Month Oil Fund (NYSEMKT: USL  ) holds equal positions in each of the next 12 futures contracts. That reduces the positive impact of near-term backwardation, but it gives you more exposure to the heavier backwardation that exists further into the future.

The key thing to remember when you buy an oil ETF is that its price isn't necessarily going to track changes in the spot crude oil price. To profit from oil ETFs, you have to be aware of the impact that contango and backwardation inevitably have on their returns.

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Read/Post Comments (2) | Recommend This Article (1)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 23, 2013, at 3:24 PM, Armcharles wrote:

    Fairly good article here, one I agree with wholeheartedly. In fact, I wrote a piece discussing this exact topic and these exact funds two weeks ago on Seeking Alpha (http://seekingalpha.com/article/1332941)

    I wanted to point out, however, a few issues with the points you raise.

    * First, you talk about WTI moving into backwardation after July 2013. Importantly however, USO only holds (and therefore only rolls) the front-month contract. As such, USO does not stand to receive ANY kind of roll bonus until near dated crude contracts (read, the first two contracts) are in backwardation. (As of writing, July and August contracts are in contango.) Therefore, USO (or any ETF that holds and rolls front-month contracts) will not outperform crude in any way whatsoever until the chain is actually in backwardation.

    * Second, you mention BNO, the United States Brent Oil Fund. Brent Crude is an entirely different standard of oil than WTI. The two currently have a roughly 80% correlation, but an investment in a Brent-backed ETF is not necessarily an investment what most American investors think of when they say "crude oil". I wrote about this issue, also on Seeking Alpha, last month (http://seekingalpha.com/article/1292141).

    All that I said, I agree with the central thesis regarding oil ETFs and their issues, and also concur that, given the current states of contango and backwardation in WTI and Brent, respectively, a long term oil bull would be best using BNO or USL.

  • Report this Comment On April 23, 2013, at 9:48 PM, TMFGalagan wrote:

    @armcharles - Thanks, Charles. Your point on USO was what I was trying to say when I wrote that if the trend persists toward greater backwardation, it could eventually help USO. But I agree that right now, the future-month backwardation isn't helping it, which is why I suggested perhaps looking at USL instead.

    As for Brent, I think most oil investors have become quite familiar with the two benchmarks, given the big price disparities that have opened up due to the explosion in U.S. unconventional production. My point is merely that in backwardation, a Brent-based futures ETF might outperform spot Brent in the long run.

    I think we agree here - just want to clarify. Thanks again for reading.

    best,

    dan (TMF Galagan)

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