A Primer on Oil ETF and a Market Review

by Vested Team
July 16, 2020
4 min read
A Primer on Oil ETF and a Market Review

Some of you might be monitoring the oil price fluctuations and considering investing in this commodity. One method to invest in oil without actually purchasing physical oil and storing it in barrels, is to buy oil ETFs. However, investing in oil ETFs is much more complex and indirect compared to investing in a typical stock or ETF, so before you invest, we’ve collated some information about them below.

Oil ETF – What is it and how does it work?

Oil ETFs are funds made up of oil future contracts. Oil futures are legal agreements to trade oil at a predetermined price at a specified time in the future. They are financial derivatives that are used to speculate and hedge on price movements of oil prices.

These ETFs (example: USO, BNO, OIL, etc) track oil futures, and as the oil futures contracts within the ETFs expire, the ETFs must roll the expiring contracts to the next contract – there are costs associated with this. Because of this reason, these ETFs do not track current oil prices accurately.

Further, there’s contango. Contango is a price structure where oil prices in the future (next month future contracts) are valued higher than the current spot price. This creates two issues:

  1. As the ETF rolls to the next month’s contract, it must sell the contracts that are expiring (at a lower price) and purchase the next month’s contract (that is more expensive). This will eat up any gains for long term investors that hold the ETFs. As such, this type of investment is not suitable for long term investments.
  2. When future contracts are valued higher than current, oil producers/traders tend to hold their supply in the hope of selling them later (to generate more profit). Because oil is a real world physical asset, it costs money to hold (storage costs, transportation costs, etc). In fact, the transportation costs of shipping oil has gone up 3X since March (see Figure 1), due to shortage of tankers (everyone is holding on to their oil inventory, waiting for the price to rebound in the future).

Figure 1: Costs to ship oil from the Middle East to China has jumped more than 3X since March. Source is from Bloomberg

Because of the reasons above, the ETFs prices poorly track oil prices. In Figure 2 below, you can see the returns of OIL ETF vs. Crude prices (note: we use the WTI spot price to represent historical oil prices). As you can see, in the long run, the ETF does not track oil prices well. When oil prices goes up, the ETF either does not go up as much or stays flat.

Figure 2: Price change comparison between US Oil Fund ETF (ticker: OIL) vs. WTI spot price from April 2006 to now

You are not alone in being tempted to buy during the dip in oil

Oil ETFs are seeing high inflows (investors buying the ETFs). Data from Bloomberg shows that, over the last three weeks, about US $1.8 billion flowed into the USO ETF (the highest level in 5 years).

Figure 3: Inflows into USO ETF. Data from Bloomberg

Why Oil Prices Have Declined

If you look at Figure 2oil prices have been in decline for the better part of the past 6 years. This trend is because of several factors:

Too much Supply

  • 2014 – 2016: The primary reason for the initial decline is due to a glut of supply – as the US became one of the largest oil producers in the world – due to the rise of fracking. Although the cost basis of US oil is much higher than Saudi Arabia, the ability of the United States to produce oil to fulfill its domestic needs breaks OPEC’s control over supply. This change is structural and likely to be permanent. Nonetheless, at current prices of US $20 – $30 per barrel, many fracking companies may go out of business (their typically breakeven price is ~US $50 per barrel).
  • March 2020: Russia and OPEC could not come to an agreement on a production cut (to limit over-supply), leading to a price war. Since Russia did not commit to limit its production of oil, Saudi Arabia decided to increase production in retaliation. This price war triggered the recent price shock. Hope of this coming to an end might be around the corner, however. After Trump tweeted that a truce between Saudi Arabia and Russia might be happening, oil prices jumped more than 25% (the highest one-day rally recorded). Nevertheless, analysts are still cautious – since the price decline in recent weeks have caused oil inventory build up to be as high as 1.2 trillion barrels (which is 3X of the 2015 price shock).

Slowing demand

  • January – March 2020: The spread of COVID-19 global pandemic has caused the world’s economy to come to a screeching halt. As a result, oil consumption is projected to contract in 2020.
  • 2020 onwards: The International Energy Agency has predicted that the increase in global oil demand will plateau by 2030, due to a combination of China’s slowing growth (China consumes about 80% of global oil demand growth) and the transition to clean energy.

Taking advantage of this low price, the Chinese government is planning on buying more oil to increase its strategic reserve.

With this mix of over supply, declining demand and contango, the most in demand resource at the moment might be tankers to store these oil.

As you can see – investing in oil is not for the faint of heart, especially when doing so through an ETF. The pricing structure and the complex dynamics between macroeconomics and geopolitical factors can significantly affect the outcome of the investment.

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