HardAssetsInvestor

Written by Cinthia Murphy  |

August 10, 2012

Price Moves Expose Oil ETF Differences

Details

As oil prices creep up on hopes of economic stimulus, investors are faced with three different choices to capture returns.

[This article originally appeared on IndexUniverse.com and is republished here with permission.]

Oil ETFs are back on the front burner, as investors look to capture some of crude oil’s recent gains amid hopes that central banks will step up and stimulate economies, alleviating concerns over global energy demand.

Investing in oil so far this year has been no easy task for the average investor, who was caught between an oil price plunge that cost oil futures 30 percent in a three-month period this spring, and some 15 exchange-traded products to choose from.

Now, as the market rebounds on hopes for better demand and easing concerns over global supplies—Saudi Arabia did come in and make up the production difference following an embargo imposed against Iran effective July 1—investors are again faced with tough choices among so many mousetraps.

The takeaway is that when it comes to oil funds and the return streams they generate, there’s no such thing as a one-size-fits-all strategy.

As United States Commodity Funds’ Chief Investment Officer John Hyland—the man behind the market’s largest oil ETF by assets, the United States Oil Fund (NYSEArca: USO)—puts it, when it comes to oil, there’s no right way or wrong way to go about picking an ETF—there’s only being certain about what your objective is.

Narrowing Your Focus

The choices are these: To own front-month West Texas Intermediate (WTI) oil exposure; own several months along the WTI futures curve; or own WTI’s European counterpart, Brent.

The differences between these choices so far this year would have either cost investors as much as a 8.5 percent loss year-to-date on a portfolio like USO, or netted them a gain of more than 6.5 percent through the United States Brent Oil Fund (NYSEArca: BNO). That’s hardly immaterial.

In a way, many look at USO as the catch-all proxy for the oil market because of the fund’s massive size—it boasts more than $1.4 billion in assets in a space dominated by much smaller funds—and its impressive liquidity: USO trades millions of shares on a daily basis.

But USO, like others in the space, such as the iPath S&P GSCI Crude Oil TR Index ETN (NYSEArca: OIL), is designed to reflect the spot price of WTI light, sweet crude oil, and as such, it owns primarily the front month on the WTI futures curve.

USO has lost 8.5 percent year-to-date because WTI has been in contango for several months, thanks in part to its abundant supplies.

When a market is in contango, its front month in the futures curve is also its cheapest, meaning investors have to pay up to roll into another contract upon expiration, something that eats up returns over time.

In WTI’s case, that currently means investors are paying about 27c a month to have exposure to a $93-94 barrel of WTI oil.

“WTI is in contango, but there’s still a good argument to owning a fund like USO if you are looking at holding it for a short period of time, as in days or weeks, assuming you are bullish oil,” Hyland said.

“In the short term, paying 20-25 cents in contango is not a big deal, but if you want to express a long-term view, that cost starts to add up,” he added.

It goes back to idea that a clear objective in an oil investment is everything.

Long-term oil exposure in the current market environment might be better served with a strategy that dilutes the effect of contango by diversifying allocation across various months in the WTI futures curve.

Funds like the $591 million PowerShares DB Oil ETF (NYSEArca: DBO) and the $109 million United States 12 Month Oil Fund (NYSEArca: USL) do just that. They each own several contracts along the curve to mitigate the impact of contango.

Their year-to-date performance shows the nuanced difference: DBO and USL have seen more modest year-to-date losses, about 6 to 7 percent.