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Investing in Oil ETPs: What You Should Know

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 Statesone 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.  

Shifting strategies

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.  

Bottom line

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. 

1The Great Shale Shut-In: Uncharted Territory for Technical Experts

2U.S., Saudi Arabia, Russia Lead Pact for Record Cuts in Oil Output.

3Benchmark Oils.

4Battle of the Benchmarks: Brent Crude Oil and West Texas Intermediate.

5The Great Crude-Oil Fireball Test.

6U.S. Energy Information Administration - EIA - Independent Statistics and Analysis.

7 FactSet, May 1, 2020

What You Can Do Next

  • Read more about Schwab’s perspective on recent market volatility.

  • Schwab clients, please reach out if you’d like discuss your portfolio. Contact your Schwab Financial Consultant or call 877-807-9240 to speak with a Schwab trading specialist.

  • If you’re not a client, learn more about trading at Schwab.

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.

Leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding, aggressive techniques, and possible correlation errors, leveraged and inverse ETFs may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETF and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives, options, can increase ETF volatility and decrease performance. Investors holding these ETFs should therefore monitor their positions as frequently as daily.

Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Past performance is no guarantee of future results.

Charles Schwab Investment Advisory (CSIA) is a team of investment professionals focused on rigorous investment manager research. 

Charles Schwab Investment Advisory, Inc. ("CSIA") is an affiliate of Charles Schwab & Co., Inc. ("Schwab").

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value.

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