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Why oil tracking ETFs might not give you quite the return you expect

Nicholas Hyett, Equity Analyst, looks at the recent oil market downturn, how this affects oil funds and what this could mean for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Since the oil price crashed in early March Exchange Traded Fund (ETFs) which invest in oil have seen a surge in investors adding new money.

Because of the difficulty and expense involved in holding physical oil, oil tracking ETFs usually invest in oil futures rather than oil itself. These contracts entitle the holder to receive a barrel of oil at a set price, location and a set date in the future. Again because of the challenges involved in handling oil itself, oil funds look to sell these contracts before delivery is due and replace them with longer dated contracts.

However, this creates some problems.

Contango and why it matters for oil funds

In normal times future oil is worth more than the current market price (known as the “spot price”). This is known as contango. It means that funds have to pay more for new oil contracts than they received for the more recent oil contracts they’ve sold.

The graph below shows the current forwards curve for oil, which is the price of a barrel of oil delivered at a set date in the future. Specifically it relates to high quality oil delivered to the Cushing Oil Terminal in Oklahoma.

You’ll notice that as contracts approach delivery they often become cheaper. That’s because they’re heading towards the current spot price. Oil futures due for delivery tomorrow should, in theory, be trading at essentially the same price as crude oil itself.

NYMEX Light Sweet Crude Oil Future Contract Price

Scroll across to see the full chart.

Source: Refinitiv, 04/05/20.

Imagine an oil fund which has 100 futures contracts which are due to mature in June 2020. These contracts are more closely priced to real physical oil, since they will deliver soon, and so are most likely to reflect movements in the spot price.

However, the oil fund doesn’t want to end up actually receiving the oil itself. So at some point it needs to sell these contracts and replace them with longer dated futures.

This is known as rolling over, and at current prices it will be a significant headwind to performance.

Consider the table below. Selling 100 June 2020 contracts would raise $1,858. However, because future contracts are more expensive than the June contracts the fund can afford significantly fewer contracts with the sale proceeds than it actually sold.

Contract Date Contract Price Cost of 100 contracts Number of new contracts bought
June $18.58 $1858.00 n/a
July $21.26 $2126.00 87

Over time you would generally expect the price of July futures to trend towards the current spot price although there are no guarantees. All things being equal that means in a month’s time July contracts will be trading at $18.58. If the fund had rolled into the July contract it would have then made a 12.6% loss.

Why’s this? Well the fund started off with 100 contracts priced at $18.58, but because it had to buy more expensive futures it only had 87 July contracts. These are now also worth $18.58 each, but only $1,625 in total.

The example above is an illustration and past performance is not a guide to future returns.

What do recent oil price movements mean for these funds?

The price of oil futures turned negative for the first time ever last month, with the May 2020 monthly contract briefly trading at -$37.63. That means you would actually have had to pay another investor to take the May contract off your hands. That’s because, as we mentioned earlier, handling and storing oil is an expensive business.

The sudden drop into negative territory was caused by oil tracking ETFs looking to roll over the oil contracts they held. With oil demand very low because of the disruption caused by the coronavirus outbreak there simply wasn’t enough demand for this oil and storage facilities were already nearly full.

Paying to get rid of your current contracts but still having to fork out for new contracts has the potential to create very large losses for oil tracking funds. More concerning will be the fact that, if oil demand remains low, the same could happen when the time comes to sell the June contract.

However, the problem of losses from rolling contracts isn’t confined to these unusual times and there will always be a headwind to some degree.

Oil tracking funds are less than accurate

The graph below compares the price of West Texas Intermediate (the benchmark for US oil prices) and the return investors would have received from an oil tracking ETF over the last five years.

It’s difficult to see from this graph but while $10,000 invested in “the oil price” would theoretically have been worth $3,254 on 30 April, the ETF investment was actually worth just $1,578. That reflects long term underperformance and has a lot to do with the negative impact of ‘rolling contracts’.

Bear in mind that this is just an example to show the tracking error that can exist in oil ETFs. What you would actually get back depends on your individual circumstances and performance of the underlying commodities as well as any ETF charges.

Oil price versus Oil ETF performance

Scroll across to see the full chart.

This is just an example - past performance is not a guide to the future. Source: Lipper IM, 30/04/2020.

5 year performance

2016 2017 2018 2019 2020
Wisdom Tree WTI Crude Oil WTC -0.346% -0.066% 0.342% -0.040% -0.582%
Crude Oil-WTI Spot Cushing U$/BBL -0.230% 0.074% 0.390% -0.068% -0.705%

Past performance is not a guide to the future. Source: Datastream, 30/04/2020.

What does all this mean?

We’re not saying that investors should steer clear from ETFs altogether. They can be a valuable way to access lower-cost investment alternatives – particularly more traditional equity or bond index tracking ETFs.

While Oil ETFs are likely to go through periods of strong performance, over the longer term investors are likely to get a return that’s quite different from what they might expect.

For more complex products, such as commodities, it’s important you understand how a fund works. The prospectus for each ETF is available through the HL website – you need to read this carefully before you invest. The Key Investor Information is also important and covers risks for the individual funds.

This article is not personal advice, if you’re at all unsure you should seek advice. All investments can fall as well as rise in value so you could get back less than you invest.


Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.


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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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