Know Your Roll – Commodity ETF Edition

The biggest macro-economic event in the past year has been the collapse in crude oil prices.  Since mid-July, WTI crude oil spot prices are down over 50%.


Source: Bloomberg

Crude is the most liquid (no pun intended) and most analyzed commodity on the planet.  Its covered exhaustively by a wide array of shareholders and stakeholders; public and private oil producers and consumers, physical traders, banks, and geopolitical think tanks just to name a few.  This is why the most interesting aspect about this huge move in crude is that no one foresaw the magnitude or velocity of this decline.  Bloomberg had an article back in December on the hedging strategy of some U.S. shale drillers which showed that those companies certainly did not anticipate a decline in crude prices like what we’ve seen.

Recently, we’ve read that some people are looking to get long crude oil – speculating that it will bounce.  Since most investors and traders cannot hold physical crude oil in storage, a popular trade being talked about is buying USO, the United States Oil Fund LP ETF, currently the largest crude ETP in the U.S. with total assets over $2.8 billion.  As opposed to the SPDR Gold Shares ETF (GLD), the largest commodity ETP in the market place with total assets over $28 billion and whose shares are back by physical gold bullion held in HSBC’s vaults in London, USO does not own physical crude oil in storage.  Instead USO invests in listed WTI crude oil futures contracts, holding them until there are only two weeks till expiration and then rolling the contract into a further dated futures contract (you can find the full details of how USO invests in crude oil futures here).  As a result, an investor in USO is concerned with two vectors, the crude oil spot price and the shape and steepness of the futures curve (i.e. the contango or backwardation).

We all know what has happened to crude oil spot prices in the past year but what about the shape of the futures curve?  Ten months ago, just before the crude sell-off began, the crude oil futures curve was in backwardation (figure 1), meaning that nearby futures contracts traded at higher prices than futures contracts further out the curve.  Since then, the futures curve has flipped into contango (Figure 2) with nearby futures contracts trading at lower prices than futures contracts further out the curve.  The 1 year out futures contract traded at an almost 9% discount to the nearby contract ten months ago, now the 1 year out futures contract trades at an almost 15% premium to the nearby contract!

Figure 1:  WTI Crude Oil Futures Curve (18 June 2014)


Source: Bloomberg

Figure 2:  WTI Crude Oil Futures Curve (10 April 2015)


Source: Bloomberg

As shown in the daily fund holdings table above, USO currently has a 25% of NAV exposure in the May 2015 futures contract and 75% of NAV exposure in the June 2015 futures contract (the rest of the holdings are in cash or cash equivalents as the margin requirement on WTI crude oil futures contracts are only 10% of the market value).  Prior to April 8, 100% of USO’s NAV exposure was in the May 2015 futures contract.  Since April 8, USO has been systematically selling their May contract holdings and buying the same market value worth of the June 2015 contracts – which is currently about 3.6% higher in price relative to the May contract.  The fund will complete this futures roll over the next few days but given the higher price of the June contract, the fund will only buy 96% of the position in the June contract that it held in the May contract.  When the fund has to roll into the July contract it will have to buy a smaller position relative to the June contract as the July contract trades at a premium to the June contract.  Run this forward for six months, 1 year, 2 years, etc…you get the picture.  For traditional equity investors, this would be akin to reinvesting a monthly dividend payment but in reverse.  Instead of getting paid a monthly dividend, you’re charged the dividend each month and to pay for this negative carry you have to sell some of your holdings.  It’s hard to make a lot of money over a year if every month you are reducing the amount you hold for no compensation.

We’ve seen this movie before.  Starting in mid-2011 to April 2012, natural gas spot prices decline by 63%.  Over the subsequent two years, natural gas prices rebound by over 145%, almost back to the price level where it started the decline three years prior.


Source: Bloomberg

Let’s say you had the good fortune to decide to go long natural gas on April 20, 2012, the day natural gas made its low price and you bought shares in UNG, the USO equivalent natural gas ETF.  While you would’ve earned a respectable 70% return over that period, your return is still be less than half of what natural gas spot prices actually returned.


Source: Bloomberg

A better way for investors to get long crude oil is actually via equity in oil producing and/or oil service companies.  A good number of these company’s stock prices having already declined to levels where they’ve more than discounted the decline in crude oil prices.  To be sure, investing in oil and oil-related companies in today’s environment is not for the faint of heart.  Many have already announced plans to preserve capital in this environment, whether that’s through reduced capital investments going forward or reduction to outright suspension of dividends.  But that’s also the beauty of our capitalist system; good companies know when to batten down the hatches to get through the current environment and how to reposition themselves for when the cycle turns back in their favor.  These are assets that you want to own even if the current prospects for dividend returns are slim to none and that’s much better than the negative dividend that you’ll face owning USO.

By the way, what if you had bought Cabot Oil & Gas (COG) – a well-known and well respected natural gas producer – back on April 20, 2012, how would that invest had done relative to natural gas spot prices or UNG?  At the end, that investment tracked the movement of natural gas spot prices very well over the holding period, returning almost 126%.


Source: Bloomberg