With oil prices at record lows, investors have been pouring into oil-centric exchange-traded products (ETPs) in hopes of a crude price rebound. But, be warned: because a fund has dropped in value, does not mean it’s a bargain. Here’s why.
Oil demand continues to drop while supplies grow
On April 20, 2020, the price of the front-month contract for West Texas Intermediate (WTI) crude fell below $0 a barrel. Unprecedented business closures and stay-at-home orders in response to Covid-19 have had a major impact on the global demand for oil. However, the supply of oil has been slower to respond to sharply reduced demand.
In the United States—one of world’s largest oil producers—shutting down wells is a complex and labor-intensive process which requires the specialized skills of petroleum engineers who are attempting to limit damage from unplanned “shut-ins.”1 In other parts of the world, geopolitical tensions have created diplomatic challenges to cutting production. 2
How oil futures vary
Over the last year, ETPs offering long exposure to oil futures have typically generated losses for investors, but returns have varied due to significant differences in the underlying indexes.
Here’s how ETPs linked to oil futures tend to vary:
- Benchmark: West Texas Intermediate (WTI) crude is the primary benchmark for oil produced in the United States, while Brent Oil is the benchmark for oil produced in the North Sea. 3 Although Brent and WTI have similar chemical properties, their prices often diverge due to factors such as ease of transportation, availability of storage, capacity of nearby refiners, other supply and demand in the region, etc. 4
- Assortment of expiration dates: Holding physical oil isn’t practical for most investors. Unlike gold, which can be neatly stored in a vault, oil is both messy and potentially flammable.5 As a result, exchange-traded funds (ETFs) typically access the oil market via futures contracts. These contracts, which are traded on commodity exchanges, specify a precise quantity of oil and date for settlement. Some ETFs hold only front-month contracts, meaning they invest in futures contracts with the shortest time to expiration. Other ETFs hold contracts with expiration dates further in the future, or they may invest in a mix of contracts with dates ranging from near- to long-term.
- Process for rolling contracts: Unlike equities, which can be held indefinitely, oil futures contracts expire monthly. For ETFs to stay invested, they must sell expiring contracts and buy contracts with more time remaining before expiration. ETF managers do this by taking an opposite position in the original contract (to close out the original position) and using the proceeds to buy longer-dated contracts.
Crude benchmarks are in super contango
Oil futures contracts are currently in steep contango, which occurs when contracts approaching expiration have lower prices than those with more time remaining. This indicates investors expect oil demand to begin recovering later this year.
While contango is present in Brent contracts, it’s exacerbated in WTI by the fact that these contracts require physical delivery to Cushing, OK. As of late April, storage facilities in Cushing, and those accessible to Cushing (primarily via pipelines), are nearing capacity.6
Contango has made the process of rolling contracts unprofitable for oil-linked ETFs. By selling contracts with lower prices and buying contracts with higher prices, these ETFs are locking in losses with every roll. ETFs that roll more frequently—those holding primarily front-month contracts—have performed worse than ETFs which are invested in longer-dated contracts and roll less often.
However, oil’s decline has been so staggering that many of the oil-linked ETPs which existed at the beginning of the year are no longer in existence. Since the end of January, 11 oil-focused ETPs have closed,7 and a number of other products have undergone reverse splits to keep their share prices above the minimum thresholds set by their listing exchanges.
Nevertheless, demand for oil-linked ETP shares has remained high. Unlike other types of ETFs, commodity-linked ETFs are required to register shares with the SEC. If commodity-linked ETFs run out of registered shares, there is a risk that the fund may trade at a significant premium to net asset value (NAV). In other words, investors who purchase shares when creation is suspended may pay more than the value of the underlying futures contracts held by the fund.
Surging demand combined with challenging market conditions have caused some funds to alter their strategies. The types of strategy changes investors should watch for include:
- Term composition – A fund may change from holding exclusively front-month contracts to holding a wider range of contract months.
- Roll period – Varying the time period over which a fund transitions out of near-month contracts and into longer-dated contracts.
- Definition of eligible contracts – Including additional contract types as eligible investments (e.g., diesel, heating oil, natural gas, and other petroleum-based fuels); Allowing futures contracts trading on international exchanges to be defined as eligible investments; Excluding contracts with the ability to be priced below $0 as eligible investments.
Investors should also be aware that significant strategy changes may make it unlikely that an ETP will track its original index or any index (in some cases). In fact, when ETF managers are given broad latitude and high levels of discretion regarding a fund’s strategy, it is possible that an ETF should no longer be considered a passive investment vehicle.
Investors should proceed with extreme caution when purchasing oil-linked ETPs. When the front-month WTI contract fell below $0 on April 20, 2020, only a few people were able to profit--primarily those with storage or transportation facilities in Cushing. For anyone not willing and able to take delivery, negative prices did not create an attractive, arbitrage opportunity.
Before making any investment, be sure to understand the investment’s strategy and its risks. For commodity-futures ETPs, investors should know the benchmark (WTI, Brent, or other type of oil), the term structure (front-month, longer-dated, or some combination), and the process used to roll contracts as they approach expiration.
Finally, although volatility is currently impacting oil markets, investors should be aware that other commodity markets could also be at risk for Covid-19 disruptions.
7 FactSet, May 1, 2020
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