This blog was updated on 2 April 2020.
With the price of oil sitting just above $20, some investors might think now is a good time to invest into an oil exposure and then sit and wait for the price 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 oil at the spot price. 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 regularly “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.
If you are selling one contract to get into the next, the difference in the prices of the two contracts 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 June contract is currently priced at $24.54 which is higher than the current (May) contract at $21.40. 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”.
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 $21.40 and the next contract priced at $24.54, if the price differential between the contracts was to remain constant till expiry of the May contract, you would lose money on the “roll”, even if the spot price of oil was to rise.
How is this so?
Let’s assume the price of the two futures contract is unchanged at the May expiry, when the roll into June futures takes place. When you, or rather the fund that is getting the exposure for you, sells out of the May contract and receives $21.40 for each contract, the fund then has to go out and buy the next contract at $24.54 which means the fund (or in our case, the ETF) can only purchase approximately 87% 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 rise at least 14.7% just to start to make money if you are going to be holding your investment over the roll period into the month of June. If you were to hold for the next 3 months to the expiry of the July contract, at which point you would be rolling into August futures, then spot oil would have to move nearly 34% for you to break even (before ETF fees, expenses and any gains from interest on the ETF’s cash deposits, and again, assuming the price differentials between the different contracts remain constant).
In summary, the outcome of your investment will be determined by:
- Spot oil price movement (negative or positive)
- Roll cost/benefit from rolling the futures contracts (negative or positive)
- Interest income (in the case of our BetaShares Crude Oil Index ETF – Currency Hedged (synthetic) (ASX: OOO), its 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 14.7% in the example above (the difference in price from the May to June contract), you will be in a loss position. 14.7% 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 May contract is $24.54, and June is priced at $21.40. If spot oil prices were to remain constant, when rolling from one contract to the next, the fund would be able to obtain 14.7% 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 by more than 12.8% (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:
- What does the current futures curve look like
- What is your price or return expectation for spot oil
- What is your expected investment holding period
If your return expectation of spot oil is greater than the expected roll cost over the timeframe 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 for oil. If there is a glut of oil, and not enough storage facilities, then 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/fund/oil-etf-betashares/#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) (ASX: OOO) 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.