ETF Investing
Invest in Oil: How to Buy Crude Oil at Spot Price?
Most energy investors need to invest in oil, but it’s impossible for average investor to buy and hold physical crude oil, and then sell it later, it’s simply too difficult. To address this problem, many investment vehicles have been created to facilitate investing in crude oil. This post talks about each of the major oil investment vehicles and their relationship to crude oil price.
Oil Prices
The often talked about oil price is not a price of a single product, but have at least two versions: spot price and futures price. Among spot price, there are two versions as well: West Texas Intermediate (WTI) Spot and Brent Spot, and WTI price is more widely used in US.
Oil ETF and ETN
Several Exchange Traded Funds were created to reflect crude oil prices, either spot or futures, so that investors can invest into this important component of commodity.
In fact, these securities are not real-sense exchange traded funds, because ETFs are supposed to hold the physical assets such as equity or commodity as underlying assets, but given the difficulty holding crude oil physically across the time, these ETFs buy and sell futures to track oil prices.
Contango and Backwardation
This way of working actually makes the price of these ETFs more complicated, the shape of futures price curve can actually affect their prices, there are two types of futures price curves: when earlier maturity futures price is lower than than later maturing futures price, it’s contango and the contrary is backwardation. Read here to learn more about contango and USO, and here about general concept of contango and backwardation.
Here is a perfect explanation of contango and backwardation from this article:
Backwardation in the crude oil futures market typically indicates that oil market fundamentals are tight, but should ease in coming months. For example, after Hurricanes Katrina and Rita, near-month crude oil futures spiked as traders fretted over supply disruptions in the Gulf and damage to refining and transport infrastructure. There were some temporary shortages of crude and gasoline in certain markets because of pipeline and refinery closures.
At the same time, most traders expected conditions to ease once pipelines were inspected and brought back online. Thus, near month futures traded at high levels relative to longer term futures–the market was in backwardation.
Contango implies that near-term oil market fundamentals are bearish but investors still expect longer-term improvement. In the late 2008 through early 2009, investors faced rapidly rising US oil inventories and an accelerating decline in global oil demand–fundamentals looked bearish.
More important, the US and global credit markets were in a state of near-total dysfunction. The lack of demand, excess supply and near cessation of business activity due to weak credit market conditions pushed down near-month futures and sent contango to record levels.
Since early this year, contango in crude oil futures markets has declined to around USD8 a barrel, still a historically stretched level. The simple recovery in contango to more normal levels accounts for about USD27 a barrel of the USD31 a barrel rally in spot prices since the beginning of the year.
With these in mind, here I give crude oil ETF and ETN a comparison.
US Oil Fund (USO)
USO portfolio: The portfolio will consist of listed crude oil futures contracts and other oil related futures, forwards, and swap contracts. USO will also invest in obligations of the United States government with remaining maturities of two years or less and hold cash and cash equivalents to be used to meet its current or potential margin or collateral requirements with respect to its investments in crude oil futures contracts and other oil interests.
USO Market Cap: $4.47 B (as of Mar. 25 2009)
USO Average Daily Volume: 34.16M
iPath S&P GSCI Crude Oil Total Return ETN (OIL)
OIL ETN: iPath Exchange Traded Notes (ETN) are senior, unsubordinated, unsecured debt securities issued by Barclays Bank PLC that are linked to total returns of market index. The iPath S&P GSCI™ Crude Oil Total Return Index ETN is a sub-index of the S&P GSCI™ Commodity Index. The S&P GSCI™ Crude Oil Total Return Index reflects the returns that are potentially available through an unleveraged investment in the West Texas Intermediate (WTI) crude oil futures contract plus the Treasury Bill rate of interest that could be earned on funds committed to the trading of the underlying contracts.
OIL Market Cap: $777.53M
OIL Average Daily Volume: 3.71M
PowerShares DB Crude Oil Double Long ETN (DXO)
DXO ETN: All of the PowerShares DB Crude Oil ETNs are based on a total return version of the Deutsche Bank Liquid Commodity Index-Oil (the “Index”) which is designed to reflect the performance of certain crude oil futures contracts plus the returns from investing in 3 month United States Treasury bills. The Long and Double Long ETNs are based on the Optimum Yield™ version of the Index and the Short and Double Short ETNs are based on the standard version of the Index. The Optimum Yield™ version of the index attempts to minimize the negative effects of contango and maximize the positive effects of backwardation by applying flexible roll rules to pick a new futures contract when a contract expires. The standard version of the index, which does not attempt to minimize the negative effects of contango and maximize the positive effects of backwardation, uses static roll rules that dictate that an expiring futures contract must be replaced with a contract having a pre-defined expiration date.
DXO Market Cap: N/A
DXO Average Daily Volume: 35.8M
PowerShares DB Oil Fund ETF (DBO)
What is DBO? The PowerShares DB Oil Fund (Symbol: DBO) (the “Fund”) is based on the Deutsche Bank Liquid Commodity Index – Optimum Yield Oil Excess Return™ (the “Index”) and is managed by DB Commodity Services LLC (the “Managing Owner). The Index is a rules-based index composed of futures contracts on Light Sweet Crude Oil (WTI) and is intended to reflect the performance of crude oil.
DBO Market Cap: $46.96M
DBO Average Daily Volume: 339,000
United States 12 Month Oil Fund, LP (USL)
What is USL? The United States 12 Month Oil Fund, LP (”USL”) is an exchange traded security that is designed to track the movements of West Texas Intermediate light, sweet crude oil (WTI). USL issues units that may be purchased and sold on the NYSE Arca. The investment objective of USL is to have the changes in percentage terms of the units’ net asset value reflect the changes in percentage terms of the price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the average of the prices of 12 Futures Contracts on crude oil traded on the New York Mercantile Exchange (the “Benchmark Futures Contracts”), consisting of the near month contract to expire and the contracts for the following eleven months, for a total of 12 consecutive months’ contracts, except when the near month contract is within two weeks of expiration, in which case it will be measured by the futures contracts that are the next month contract to expire and the contracts for the following eleven consecutive months, less USL’s expenses. When calculating the daily movement of the average price of the 12 contracts each contract month will be equally weighted.
USL Market Cap: $3.18M
USL Average Daily Volume: 513,000
MacroShares $100 Oil Up Trust (UOY)
What is UOY? MacroShares are issued in pairs: When MacroShares $100 Oil Up are created, an equal number of MacroShares $100 Oil Down are also created.
UOY Market Cap: $7.29M
UOY Average Daily Volume: 15,000
Conclusion
If you compare the chart of WTIC to the charts of 5 oil ETFs or ETNs, none of the oil investment vehicles tracks oil price movement perfectly, the closest match to spot oil price is DXO. It reflects the fact that all the available oil investment vehicles can only mimic oil spot price movement, but none of them can perfectly track spot price.
HardAssetInvestor ran a great article in Feb 2009 to compare the USO and USL, sister funds run by same company, focusing on their pricing structure and impact of contango and backwardation, the conclusion is that USO is more vulnerable to contango situation, while USL may be newer fund to USO therefore not as liquid as USO, but USL addresses contango problem and is liquid enough to serve as a good oil spot price investment vehicle.
Sources:
How do you buy spot oil?
Julian Murdoch
Important Disclaimer: Product price and availability are accurate as of the date of most recent update. Please send correction requests to info@linked8.com
Investing: Myths and Facts about Leveraged ETF
WSJ ran an article today by Jason Zweig, a personal finance columnist to WSJ. To a great extent, the article demystified leveraged ETF, what you can expect from it or not. So the question now is will those unleveraged ETF such as SPX and GLD not backfire like leveraged ETFs might?
…And if you don’t understand how these funds work, you could take a bullet yourself. Their returns are predictable relative to the index only if you own them for one day or less. Over longer periods, say a week or more, these funds can wander wildly away from the underlying index.
When a market is trending in the same direction, a leveraged ETF can race ahead as it adjusts its leverage to its rising assets, jacking up its exposure to the market’s next move. Last Nov. 4 through Nov. 20, the Russell 1000 index of large stocks kept falling until it lost 25.6%. In response, Direxion Large Cap Bear 3X, an inverse fund, went up even more than its triple target; it rose 109.2%, four times as much as the Russell went down.
What happens when a market doesn’t take a straight path? Let’s say you were bearish on China and invested $10,000 in ProShares UltraShort FTSE/Xinhua China 25 on Oct. 9, 2008. Each day the Chinese market went down, this double-reverse fund went up twice as much. It also fell twice as much on any day when China rose.
These swings make it hard for a leveraged fund to match its targeted return in the long run; each loss requires a bigger gain just to get back to break-even. As the Chinese market heaved up and down over the next nine tumultuous trading days, $10,000 invested in Chinese stocks would have dropped to less than $9,200, a cumulative loss of 8%. Did the ultra-short fund deliver twice the opposite, or a 16% gain? No: According to data from Morningstar, it shriveled to $7,838, a 21.6% loss. So much for longer-term hedging.
…
The bottom line: Leveraged ETFs are for day traders. You can’t manage long-term risk with a short-term tool — especially not with one that can blow up in your face.
Source:
Managing Risks With ETFs Can Backfire
Important Disclaimer: Product price and availability are accurate as of the date of most recent update. Please send correction requests to info@linked8.com