Barchart.com ETF Research
Petroleum ETPs – Beware of the Contango Gremlins
ETF Research written by the Barchart.com ETF Research Team
Last updated: September 24, 2010
Table of Contents
Petroleum exchange-traded products (ETPs) are designed to track crude oil futures prices and product prices such as gasoline and heating oil. There are a variety of both exchange-traded funds (ETFs) and exchange-traded notes (ETNs) in this sector, which we will refer to in general as ETPs. Please see our article on "Introduction to ETFs" for a discussion of the differences between ETFs and ETNs.
Our view is that the petroleum and natural gas markets are very different markets and should be analyzed separately. We have produced a separate report for natural gas ETPs. Petroleum in the United States is used almost exclusively for transportation fuel and only a minor portion is used for heating oil or for electricity generation. Natural gas, on the other hand, is used by utilities to generate electricity and by households for heating and cooking. There is only a modest demand overlap between the two markets, with petroleum tied mainly to the transportation sector and natural gas tied mainly to utility sector. In addition, crude oil is a global product that can be transported fairly easily across the ocean. Natural gas, on the other hand, is much more of a regional product due to the difficulty and expense of transporting liquefied natural gas (LNG) across the ocean.
The investment case for crude oil prices is tied mainly to rapid economic growth in developing countries such as China and India and their strong demand for transportation fuel. In developing countries, by contrast, demand for crude oil is likely to be flat in coming years and may even decline. CEOs of Exxon and BP have both said that they believe U.S. gasoline demand is headed lower and that they may never sell more gasoline in the U.S. than they did in the peak year of 2007. U.S. gasoline demand is being undercut by improved vehicle mileage requirements, gasoline-electric hybrids, and biofuels, which now account for about 7% of U.S. fuel usage. Nevertheless, any significant decline in crude oil usage in the U.S. and the rest of the developing world will be a very slow process and crude oil will continue to be the transport fuel of necessity for at least the next several decades.
The supply picture for crude oil is currently plentiful due to poor demand and the lackluster global economy. However, supply is likely to tighten in coming years because demand will revive and because major oil companies are not investing in new reserves at a fast enough rate to replace depletion. Furthermore, reserves are becoming much more expensive to exploit, meaning that oil prices will have to move higher in order to provide an incentive to oil companies to develop these new reserves. The stronger demand picture, combined with the constrained supply outlook in coming years, could result in sharply higher crude oil prices over the next 3-10 years.
It is also important to recognize, however, that burning fossil fuels causes severe smog and pollution in the world as well as being a contributing factor to climate change according to the vast majority of scientists. Thus, we are already in a world where crude oil is on the wrong side of history and will eventually need to be phased out, likely causing an eventual plunge in oil demand and oil prices. Our view is that investors who are bullish on crude oil should remain cautious and should not blindly buy petroleum investment vehicles on a multi-decade basis.
We cannot stress enough that petroleum ETPs often do not closely track oil prices. This is because of the shape of the futures curve, as we explained in our report, "Commodity ETP performance and the importance of the futures curve and contango." A petroleum ETP that rolls forward in the front-month futures contract can severely underperform spot crude oil prices when the futures curve slopes steeply upward, a situation that is called "contango." By contrast, a downward sloping futures curve (which is called "backwardation") actually improves the returns of a petroleum ETP. Figure 1 illustrates how the whole group of crude oil ETPs (that will be discussed shortly) severely underperformed spot West Texas Intermediate (WTI) crude oil in the past two years. This is a major warning sign for investors that petroleum ETPs are more complicated than they look and do not move one-for-one with spot crude oil prices. Investors need to carefully assess the shape of the futures curve before making any investment in a petroleum ETP.
Figure 1: Crude Oil ETPs versus Spot WYI Crude Oil
Figure 2 illustrates the shape of the futures curve relative to spot WTI crude oil futures in the past 5-1/2 years. The blue line in the bottom panel shows the first futures contract minus the second futures contract. A negative spread means the market is in contango with the second contract trading at a higher price than the first contract. A positive spread means the market is in backwardation where the first futures contract is trading at a higher price than the second contract. The green line in the bottom panel of the chart shows the first crude oil futures contract minus the twelfth (1-year out) futures contract. The chart in Figure 2 shows that the crude oil market was in contango from early 2006 through about the end of 2007, went into backwardation as crude oil prices rallied in the second half of 2007 and first half of 2008, and then went back into a steep contango when oil prices plunged from the record highs in the second half of 2008.
Figure 2: Crude Oil Prices versus Futures Spreads
Table 1 below provides a summary of the ETPS in the petroleum and diversified energy sector. First we will take a look at the six unleveraged crude oil ETPs. An unleveraged ETP is one in which the ETP’s value should move by about 1% for a 1% move in the underlying commodity, aside from expenses, the roll yield, and the return on excess cash. After that we will take a look at leveraged crude oil ETPs, short crude oil ETPs, petroleum product ETPs, and diversified energy ETPs that include natural gas.
Table 1: Summary Table of Petroleum & Diversified Energy ETPs
United States Oil Fund LP ETF (USO) – USO is the largest petroleum ETF by far with $1.7 billion in assets under management (AUM) as of September 2010. USO rolls forward in the front-month West-Texas Intermediate crude oil futures contracts at the CME Group (Nymex) and the Intercontinental Exchange (ICE). As of September 17, 2010, for example, the fund was long 11,600 contracts of the CME/Nymex November 2010 Crude Oil Futures contract, 10,000 contracts of the ICE November 2010 WTI Crude Oil Futures contract, and 2,000 contracts of the CME/Nymex November 2010 Crude Oil (Financial) Futures contract. As Figure 1 shows, USO was the second worst performer during the period when oil prices recovered from the post-crisis low in 2009-10.
iPath S&P GSCI Crude Oil Total Return Index ETN (OIL) – OIL is the second largest petroleum ETP product with $593 million in assets under management as of September 17, 2010. The underlying index is the S&P GSCI Crude Oil Total Return Index (symbol: SPGSCLTR). OIL is an exchange-traded note (ETN), which means it has the added risk of being an unsecured debt obligation of Barclays Bank. Barclays Bank is currently rated AA- by S&P and Aa3 by Moody’s, but if Barclays should suddenly declare bankruptcy for some reason, an investor in OIL could lose his or her entire investment. The underlying index for OIL progressively rolls forward in the front-month CME/Nymex futures contract. As Figure 1 shows, OIL was the worst performing crude oil ETP during 2009-10.
PowerShares DB Oil Fund ETF (DBO) – DBO is the third largest petroleum ETF with $553 million in assets under management as of September 17, 2010. This fund tracks the Deutsche Bank Liquid Commodity Index - Optimum Yield Crude Oil Excess Return™ (Symbol: DBOLIX). The ETF uses what Deusche Bank calls its "Optimum Yield"TM methodology for seeking to "minimize the effects of negative roll yield that may be experienced by conventional commodities indexes." A description of the roll process is contained in the DBO prospectus (p. 8). The index is rolled each period into the futures contract that produces the best "roll yield," which the prospectus says has the effect of minimizing the negative effects of contango and maximizing the beneficial effects of backwardation. As Figure 1 illustrates, DBO had the best performance of the crude oil ETPs during the 2009-10 period, although it still far underperformed the spot price.
United States 12 Month Oil Fund LP ETF (USL) – USL is operated by the same issuer as USO except that this ETF spreads its position evenly among the front 12 West Texas Intermediate crude oil futures contracts, as opposed to USO which concentrates its entire position in the front-month futures contract. This ETF had $148 million in assets under management as of September 17, 2010, much less than $1.7 billion in USO. The fund’s daily holdings as of September 17, 2010 included about 155 futures contracts in each of the 12 CME/Nymex futures months running from November 2010 through October 2011. This fund is designed to reduce the impact of roll yield on the overall return of the fund by spreading out the positions over the first 12 months of WTI futures market. As Figure 1 illustrates, USL performed significantly better than its sister product USO over the 2009-10 during the time of steep contango. Nevertheless, contango affected all of the first 12 months of the crude oil futures market, meaning USL was still hit hard during that period of contango.
PowerShares DB Crude Oil Long ETN (OLO) – OLO is an ETN backed by Deusche Bank AG and had only $17 million in assets under management as of September 17, 2010. The ETN is linked to the DB Optimum YieldTM Crude Oil index.
United States Brent Oil Fund ETF (BNO) – BNO is an ETF that tracks Brent crude oil futures, which are traded at the ICE Exchange. Brent crude oil is the type of crude oil that is extracted from under the North Sea. This ETF as of September 17, 2010 had only $11 million in assets. This ETF rolls forward in the front-month futures contract.
Investment conclusions for unleveraged crude oil ETPs – First, we need to reiterate that petroleum ETPs often do not closely track spot crude oil prices. In our opinion, petroleum ETPs are limited-use investment vehicles that we recommend only for more sophisticated investors who understand roll yields and understand the bet that they are placing. We would advise investors who do not want to worry about contango and roll yields to either buy futures contracts directly for shorter-term trades or buy oil company stocks.
For investors who understand roll yields and still want to invest in a crude oil ETP, our pick for this group is PowerShares DB Oil Fund ETF (DBO). Figure 1 illustrates that DBO performed the best of its peers during the 2009-10 recovery rally, although its performance was still far below spot WTI crude oil prices. Deutsche Bank’s "Optimum Yield" process for rolling futures contracts produced favorable results relative to its peers during the 2009-10 period when the crude oil futures market was in contango, as seen in Figure 3 below. However, DBO underperformed USO during late-2007 and early-2008 when the crude oil futures rallied sharply and the futures market was in backwardation. Still, DBO’s net performance is better than USO overall and we like the goal of the "Optimum Yield" method of trying to minimize the impact of contango and take full advantage of backwardation.
Figure 3: DBO vs USO and WTI Crude Oil Spot Prices (live chart)
Regarding the other ETPs in the unleveraged crude oil ETP group, we like the United States 12-month Oil Fund (USL) better than its sister product and the largest ETF in the group of the United States Oil Fund (USO). USL spreads its position across the first twelve crude oil futures contracts, showing performance close to USO in 2008 and then substantially outperforming USO in the 2009-10 period, as seen in Figure 4 below. We would avoid the two ETNs in the group (OIL and OLO) simply because these products are not sufficiently superior to the ETFs in the group to justify taking on the extra risk of an ETN. We advise investors to avoid the U.S. Brent Oil Fund ETF (BNO) due to its very low asset level of $11 million.
We should point out that USO faces some potentially serious regulatory risk because it has grown so large that the Commodity Futures Trading Commission is considering whether to impose tighter position limits on ETF funds. The Securities Exchange Commission is also reviewing the use of futures and derivatives by ETPs. Position limits on futures, and eventually perhaps on over-the-counter swaps, could force USO to change its holdings, change its structure, or even potentially shut down altogether and return its cash to shareholders.
Figure 4: USL versus USO and Spot Crude Oil (live chart)
ProShares Ultra DJ-UBS Crude Oil ETF (UCO) – UCO seeks daily investment results, before fees and expenses, that correspond to twice (2x) the daily performance of the Dow Jones—UBS Crude Oil Sub-Index SM. The fund’s literature warns that, "This ETF seeks a return of 200% of the return of an index (target) for a single day. Due to the compounding of daily returns, returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period." The fund as of September 17, 2010 had $408 million in assets and held $349 million in November 2010 CME/Nymex Crude Oil Futures contracts and a swap with a notional value of $492 million. The swap gives the UCO its leverage.
Investment conclusion on UCO - Our main gripe about UCO is that it simply rolls front-month futures contracts and makes no effort to mitigate the impact of contango. Our recommendation would be that if an investor wants to gain some leverage in a crude oil ETF, simply buy our unleveraged DBO pick with 50% margin in your brokerage account, if you have margin privileges, thus getting a similar 2x leverage effect to UCO with a better futures roll procedure.
There are currently four crude oil ETP products that given investors a "short" position in crude oil, meaning that as oil prices go down, the price of the ETP should go up, and vice versa. If you are short the crude oil market, you should make a profit if crude oil prices fall. Short ETP products give investors a cheaper and easier way to short the market without have to go through the process of shorting an ETP, which involves borrowing the ETP through your brokerage firm and then selling it short in your brokerage account. With a short ETP, you simply buy the short ETP product in your brokerage account like any other ETP or stock, except that you are now short the market.
There are two different types of short crude oil ETPs – leveraged and unleveraged. With an unleveraged short crude oil ETP, the ETP should gain in price by about 1% for every 1% decline in crude oil prices (and vice versa), aside from expenses, the roll yield, and interest on excess cash in the fund. In other words, a short unleveraged crude oil ETP should move about one-for-one with crude oil prices except in the opposite direction. With a 2x leveraged short crude oil ETP, the ETP should gain in price by about 2% for every 1% decline in crude oil price (and vice versa), aside from expenses, the roll yield, and interest on excess cash in the fund. The 2x leveraged short ETP should move about twice as fast as crude oil prices in the opposite direction.
PowerShares DB Crude Oil Double Short ETN (DTO) and PowerShares DB Crude Oil Short ETN (SZO) – These are sister products with DTO being a double-short (2x) product and SZO being an unleveraged single- short (1x) product. Both products are linked to the Deutsche Bank Liquid Commodity Index, which simply rolls front-month futures contracts forward and does not use the "Optimum Yield" methodology used by OLO for the long version of this product. In a short product, contango will help returns while backwardation will hurt returns, the opposite as for a long product. The double-short DTO ETN has $66 million in assets under management (AUM) and has the highest AUM of the short crude oil ETP group. Single-short SZO has a negligible AUM of $10 million. Both these products are ETNs and are senior unsecured obligations of Deutsche Bank AG, London Branch.
ProShares UltraShort DJ-UBS Crude Oil ETF (SCO) – SCO "seeks daily investment results, before fees and expenses, that correspond to twice (2x) the inverse (opposite) of the daily performance of The Dow Jones—UBS Crude Oil Sub-IndexSM." SCO is the sister product of the ProShares double-long UCO product. The fund holds short futures contracts to gain its short 2x exposure to crude oil prices. SCO as of September 17, 2010 had $46 million in assets under management and held $35 million worth of November 2010 CME/Nymex futures contracts as well as a swap worth a notional $60 million. The fund rolls forward in the front-month futures contract, which means that it benefits from contango and is hurt by backwardation since it a short fund.
United States Short Oil Fund LP ETF (DNO) – DNO is a 1x unleveraged short crude oil ETF fund. The fund as of September 17, 2010 had only $19 million of assets under management. The fund rolls forward short positions in front-month CME/Nymex crude oil futures contracts.
Short Crude Oil ETP Investment Conclusions – Our pick for this group is the ProShares UltraShort DJ-UBS Crude Oil ETF (SCO), which has the advantage of being an ETF and rolls forward in the front-month contract, which is a good thing for a short fund in a contango market. On the negative side, however, the fund has only $46 million in assets, which raises some questions about its long-term viability. On the risk side, investors should remember that this is a 2x leveraged product, which means it should move about twice as fast as spot crude oil prices. Figure 5 shows SCO versus spot WTI crude oil prices. Investors should remember that an alternative to buying a short crude oil product is simply taking a short position in a long crude oil ETP product such as DBO, if your brokerage firm provides you with such shorting privileges.
Figure 5: ProShares UltraShort DJ-UBS Crude Oil ETF (SCO) versus Spot WTI Crude Oil (live chart)
United States Gasoline Fund LP ETF (UGA) – UGA has gained some traction since its launch in February 2008 and has $65 million in assets under management. UGA tracks CME/Nymex RBOB gasoline futures prices and rolls forward in the front-month futures contract. As Figure 6 shows, UGA has significantly underperformed gasoline prices in the past two years, which is not surprising since the gasoline market has been in contango during most of that time.
Figure 6: United States Gasoline Fund LP ETF (UGA) versus RBOB Spot Gasoline Prices (live chart)
United States Heating Oil Fund LP ETF (UHN) – UHN has not gained any traction since its launch in April 2008 and has only $8 million in assets under management (AUM). Due to the small AUM, we would advise staying away from this product. In addition, like other petroleum ETPs, UHN has underperformed the spot market over the past two years due to contango markets, as seen in Figure 7.
Figure 7: United States Heating Oil Fund LP ETF (UHN) vs Spot Heating Oil (live chart)
There are two main energy ETPs that invest in both petroleum products and natural gas: PowerShares DB Energy Fund ETF (DBE) and ELEMENTS Rogers Intl Commodity Index - Energy Total Return ETN (RJN). There are three other smaller energy ETPs that we will not discuss in detail because their assets under management are currently under $15 million, which include iPath Dow Jones-UBS Energy Subindex Total Return ETN (JJE), ProShares Short Oil & Gas ETF (DDG), and UBS E-TRACS CMCI Energy Total Return ETN (UBN).
As we mentioned at the beginning of this report, the petroleum and natural gas markets are very different and that investors may want to stick to ETPs that specialize in those markets. However, we will discuss these ETPs for any investors that would like to obtain exposure to both petroleum and natural gas prices in one ETP.
PowerShares DB Energy Fund ETF (DBE) – DBE was launched in January 2007 and has attracted $229 million in assets under management, which is much lower than the $1.7 billion in the United States Oil Fund ETF and $2.5 billion in the United States Natural Gas Fund ETF (UNG). The DBE fund is based on the Deutsche Bank Liquid Commodity Index - Optimum Yield Energy Excess Return™. The fund is mainly a petroleum fund with 90% in petroleum products and 10% in natural gas. Specifically, the target weights are 22.5% on light sweet crude oil, 22.5% on heating oil, 22.5% on Brent crude oil, 22.5% on RBOB gasoline, and 10.0% on natural gas. However, the weights are only reset once a year in November and thus may vary substantially during the rest of the year. As of September 17, 2010, for example, natural gas had a weight of only 7.4%. This fund follows the same Deutsche Bank "Optimum Yield"TM strategy as described earlier for DBO where the fund invests in the futures contract that produces the highest roll yield. As of September 17, 2010, for example, the fund held July 2011 WTI crude oil futures contracts, November 2010 RBOB gasoline futures contracts, June 2011 Nymex heating oil futures contracts, November 2010 Brent crude oil futures contracts, and October 2011 natural gas futures contracts. This fund in theory should therefore perform better than funds that simply roll front-month contracts.
ELEMENTS Rogers Intl Commodity Index - Energy Total Return ETN (RJN) – RJN has relatively low assets under management of $44 million. In addition, RJN is an ETN that is backed by the Swedish Export Corp, which adds an additional layer of risk to the investment. RJN is the Energy portion of the larger Rogers International Commodity Index. RJN has a weight breakdown as follows: 47.73% crude oil, 31.82% ICE Brent oil (for an overall 80% weight on crude oil), 6.82% on RBOB gasoline, 6.82% on natural gas, 4.09% on heating oil, and 2.73% on ICE gas oil.
Investment conclusions for diversified energy ETPs – Our pick for the diversified energy ETF group is PowerShares DB Energy Fund ETF (DBE), which is an ETF rather than an ETN, has plenty of assets under management, and uses the Deutsche Bank "Optimum YieldTM methodology to try to mitigate the effects of contango. However, we should point out that DBE does not provide much of an advantage over its sister product, PowerShares DB Oil Fund ETF (DBO), which is our pick for the crude oil ETP group. On its face it might appear that an investor is getting a more diversified product with DBE since it invests in crude oil as well as gasoline, heating oil, gasoil, and natural gas. However, the reality is that the only real diversification comes with natural gas since gasoline, heating oil, and gasoil trade with a high degree of correlation with crude oil. In addition, DBE has underperformed DBO over the past 1-1/2 years, as seen in Figure 8.
Figure 8: PowerShares DB Energy Fund ETF (DBE) versus PowerShares DB Oil Fund ETF (DBO) (live chart)
In a separate article we will discuss the alternative of buying an ETF that holds oil company stocks rather than petroleum itself. Oil company stocks trade with a moderate degree of correlation with crude oil prices and usually pay dividends as well, thus providing investors with a potentially attractive alternative compared to investing in petroleum ETPs, which have the attendant problems of roll yields and contango.
From the Barchart.com/ETF Research Team