Crude Oil - Ahead of the Curve? | BetaShares

Crude Oil – Ahead of the Curve?

BY Justin Arzadon | 15 March 2016
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With the price of oil below $40, some investors might think now is a good time to invest into an oil exposure and then sit and wait for the price of oil to eventually rebound. However, investing in oil isn’t that simple. In this post for the BetaShares Academy, I describe the ‘ins and outs’ of investing in crude oil.

Unless you were to own a storage tanker to physically hold the oil, it’s virtually impossible to invest in the spot price of oil. So the most common way of getting exposure is through futures contracts such as those over WTI or Brent. The issue with investing in futures contracts directly, however (apart from the complexity of actually doing this), is that they expire according to a predetermined schedule, which means you need to “roll” from one contract to the next to stay invested. In other words, you need to sell the contract that you are currently holding before expiry, and purchase the next contract to maintain your exposure to oil.

Now if you are selling one contract to get into the next, the price of the next contract is going to be important as it will have an impact on your investment. The prices of futures contracts for subsequent periods is known as the ‘futures curve’.

Let’s take a look at the current WTI Crude Oil futures curve by looking at the upcoming futures contracts:

You’ll notice that the May contract is currently priced at $38.18 which is higher than the current (April) contract at $36.30. When each subsequent month on the futures “curve” is priced higher than previous contracts, this is known as “contango”. If the subsequent months are priced lower than previous months, then the curve is in “backwardation”.

Now why does contango or backwardation matter to your investment? Because it represents a cost or benefit to your investment. In other words, depending on what the futures curve looks like, it can reduce or increase returns.

With the current crude oil futures contract priced at $36.30 and the next contract priced at $38.18, if prices were to remain constant till expiry, you would actually lose money on the “roll” even though you would see a higher price of oil once the contracts went into May. Now you must be thinking, how could this be? The price of oil is higher and you’ve lost money? The reason is because when you (or the fund that is getting the exposure for you) sells out of the April contract and received $36.30 for each contract, the fund then has to go out and buy the next contract at $38.18 which means the fund (or in our case, the ETF) can only purchase approximately 95% of the oil exposure it had from the previous month due to the higher contract price.

It’s still possible to make money in a contango environment, but the way you have to look at it is the spot price of oil has to move at least 5.17% just to start to make money if you are going to be holding your investment over the roll period into the month of May. If you were to hold for the next 3 months to July, then spot oil would have to move at least 10.71% for you to break even (before ETF fees, expenses and any gains from interest on the ETF’s cash deposits).

In summary, the outcome of your investment will be determined by:

  1. Spot oil price movement (negative or positive)
  2. Roll cost/benefit from rolling the futures contracts (negative or positive)
  3. Interest income (in the case of our ETF, it’s cash holdings generating interest)

If you are familiar with how betting lines on footy games work it is very similar. Let’s say you are placing a bet on the winning margin of a footy game and the spread is 5 points for the Roosters to win over the Storm. For you to win your bet on a Roosters victory, the Roosters would have to win by 6 or more points. If the Roosters fail to clear the spread, even though they may still win the game, your bet is a loser.

For an investment in oil going out one month, think of the price difference in contracts as the spread. Oil may go up, but if it does not go up at least 5.17% in the example above (the difference in price from the April to May contract), you will be in a loss position. 5.17% is the move oil has to make just for you to break even (or clear the spread). Anything more than that becomes your gain or profit.

Now let’s take a look at the reverse situation of backwardation through our betting analogy. If you were to bet on the Storm, as long as they don’t lose by more than 5 points, your bet is a winner.

This is similar to a position in a backwardation environment. In backwardation, the price can remain constant or even fall, and you can still make money, as long as the price does not fall by an amount greater than the difference in price from one contract to the next.

Example: Assume the April contract is $36.30, and May is priced at $34.18. If spot oil prices were to remain constant, when rolling from one contract to the next, the fund would be able to obtain 5.8% more exposure which would result in a gain. In fact, your position would result in a gain, as long as spot oil did not fall below the price of $34.18 (before any ETF fees, expenses and any gains from interest on ). How good is that? The price can drop, and you can still make money!

All this means that when looking to invest in oil, you should be thinking of 3 things:

  1. What does the current futures curve look like
  2. What is your price or return expectation for spot oil
  3. What is your expected investment holding period

If your return expectation of spot oil is greater than the expected roll cost over the time frame you plan to hold the investment (and ignoring any ETF fees, costs or interest income), then you would have a positive return expectation. However, if your return expectation is less than the expected roll cost over the time frame you are looking at, then you would have a negative return expectation, and thus may choose not to invest.

Why is there contango and backwardation?

Think of contango and backwardation as the price of storage worked into the futures contracts. If you were to invest in physical oil, you would need to own or rent a storage tanker which would cost money, and the cost would be relative to the current demand in oil. If there is a glut of oil, and not enough storage facilities, than the price of storage will be expensive, leading to a steep futures curve and a potential contango situation. However, if there is strong demand for oil this would result in a lot less storage being used, and the cost of storage would fall, which would lead to a relatively flat futures curve and a potential backwardation situation.

As you can see, there is more to investing in oil than whether the spot price moves up or down. It’s important to be aware of the futures curve and the investment time frame you are looking at. By being aware, you can make better investing decisions which will hopefully lead to positive returns!

At BetaShares, we provide a helpful link to the WTI Crude Oil futures curve on our website, via this link: https://www.betashares.com.au/products/name/crude-oil-index-etf-currency-hedged-synthetic/#each-resources

How can I get exposure to oil?

Armed with some knowledge about futures and futures curves, investors can use the BetaShares Crude Oil Index ETF – Currency Hedged (Synthetic) to obtain exposure to oil.

Oil ETFs may still offer a very compelling means of oil exposure, even in instances of contango (and even more likely in instances of backwardation) for the following reasons:

  • The contango in the futures curve is no different to the real storage and financing costs you would face if you were theoretically able to buy physical oil and store it.
  • For short term holding periods, the impact of contango may be minor or even fully offset by positive carry (interest) on cash the ETF holds.
  • For longer term holding periods, the impact of contango may be larger but may be partially offset by positive carry (interest) on cash the ETF holds.
  • Oil ETFs have provided significantly higher historical correlation to “spot” oil movements compared to major oil companies.
  • Oil ETFs are not subject to management risk, development risk or production risk, unlike oil companies.

 

The index which OOO aims to track is based on the price of WTI crude oil futures contracts. Investing in commodity futures is not the same as investing in the “spot price” of a given commodity. As such, OOO does not aim to, and should not be expected to, provide the same return as the performance of the spot price of oil. The performance of ETFs that are linked to commodity futures may be materially different to the spot price for the commodity itself.

4 Comments

  1. Tara  |  March 17, 2016

    Great article – but what happens if you don’t sell your contract before it expires?

    1. Jeremy Benson  |  May 29, 2018

      Hi Tara,

      Thanks for your enquiry. Most futures contracts are settled in cash when they expire (profit/loss is credited to your account), or in some cases, the holder of the expired contract will have to take physical delivery of the underlying asset.

  2. Jake Kim  |  March 31, 2020

    Hi,
    Is it always bad to obtain the units(OOO) towards the end of the calendar month as the contact is to be changed to the next month?
    Let’s say I’ve purchased the unit on 30 March then do I pay the roll out fee straight away as it goes into April?
    Thanks.

    1. Benjamin Smith  |  April 3, 2020

      Hi Jake,

      Thanks for reaching out.

      The S&P GSCI Index rolls the futures contracts into the next front month over the days prior to the settlement date. Roll return will be incurred at this time (either a cost when the curve is in contango, or a gain when in backwardation). In the case of the May 2020 contracts, this settlement date is the 21st of April.

      Sincerely,

      BetaShares Client Services Team

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