Oil ETPs and the double-edged sword of simplicity

April 21, 2016 01:00 PM

The simplicity of trading crude oil exchange-traded funds (ETF) is both its biggest advantage and biggest risk. ETF traders are tempted to make simple decisions based on recent price moves. What’s lost in that simple ETF snapshot is the term structure of oil futures, and the headwinds or tailwinds ETFs and exchange-traded notes (ETN) face in tracking their index or rolling positions. You can’t analyze oil investing without an assessment of the current futures price term structure, and the current futures price term structure is subject to rapid change.

Energy futures traders go long or short with respect to specific expiry dates. Even traders who have no intention of taking or making physical delivery of oil trade to precise settlement dates and terms. ETFs and ETNs eliminate the need for traders to select or manage an expiration, but in doing so they subject them to a rigid pre-determined futures roll strategy that impacts returns whether or not oil prices move. 

Historically the annualized return effect of rolling WTI futures is estimated at around 5% to 10% per year. In contrast, early 2016 saw monthly roll levels equal and exceed 5% per month—an annualized level of more than 50% (see “Contagoed,” below). 

It is important to appreciate that futures roll costs affect an ETF every day, not just on the roll. As a quick simplification, long-side investors can face a 5% per month headwind that comes from just holding and rolling front futures without any change in price. “Contangoed” shows the level of price decline (or contango) between the second and first month WTI crude oil futures contracts from mid-2014. What’s notable is that the 30-day differential is at a relative high $1.81 while oil prices are at multi-year lows below $40 per barrel.

Oil market historians like to point out that throughout most of its history the oil market has been in backwardation (forward futures prices below near futures prices). However, in practice, and during the era of the modern ETF, investors more commonly have faced contango. This has grown so daunting that many strategies have been developed to offset the cost of contango to long-term long-only strategies, such as buying a yearly basket of contracts.

In January, crude saw average daily moves approaching 4%, and a 40% upward price spike. Correct calls on momentum, reversals, geopolitical events or other signals can generate material returns during very short time horizons. While contango and backwardation can materially effect any trade, opportunities exist with careful execution and monitoring. 

ETF investors can find oil price levels across various expiries through any charting package. Unlike many markets, WTI crude oil (CL) has liquidity throughout the curve and trades 10 years out. 

What do ETFs and ETNs do?

ETFs and ETNs trade futures or otherwise manage their positions in alignment with futures roll schedules where futures contracts are held an average of 20 trading days and are then rolled to the next contract—and the cycle repeats. Like any other oil trader, ETFs are looking for near expiration price exposure, but not so near that physical barrels come into play. Funds that follow the S&P Goldman Sachs Commodities Index (GSCI) cycle hold the near-term contract until the fifth to ninth trading day of the month, at which point they sell the nearest contract for the following month’s contract. Many ETFs and ETNs follow the GSCI roll schedule—those that depart from the GSCI roll schedule usually have a similar early in the month, multi-day roll schedule.

Current WTI crude oil futures open interest is approximately $60 billion across the full range of futures expiries. At the same time, net long WTI crude interest in ETFs and ETNs is approximately $10 billion. While the ~16% footprint (10/60) of ETPs to all futures doesn’t seem overwhelming, the actual measure is closer to 60% when ETF and ETN net exposures (of $10 billion) are measured against the front futures contract outstanding of $16 billion (10/16)—recalling that most ETFs and ETNs roll in and out of the front contract. 

In short, timing is a more critical component of oil trading strategies compared to other markets and indices.  The timing of entry, exit and the duration of holding can have a material effect on returns. When roll costs are high, the need for careful entry and diligent monitoring is heightened. Also, when ETF and ETN oil exposures make up a material percentage of the largest and most liquid futures contracts, it’s likely that ETF and ETN inflows (creations) and outflows (redemptions) will have an effect on price levels and term structure — not just on the roll dates, but all the time.

Despite its importance and growth, the oil ETF market has seen little in the way of innovation. Investors should expect the ETF industry to address the potentially reflective price effects ETFs have on their underlying futures markets, and the variety of offerings for both market direction and expirations.

About the Author

Jack Fonss is CEO and co-founder of AccuShares in New York. His 20 years of experience spans fixed income, equities, currencies and emerging markets.