Markets

Buying Oil ETFs On A Dip

WTI futures have tumbled almost 14 percent in the past week from $97 to around $83.33, more than 4 percent of which occurred today. Brent futures, which currently trade at a premium to WTI, are down almost 9.4 percent to $105.98. Nearby Brent was as high as $120.40 a week ago.

So, is this pullback a sign of depressed oil prices to come, or an opportunity to profit from prices that are bound to head back up?

While the stock market dropping is a cause for concern, it doesn’t mean oil is certain to decline too. The S&P 500 reached a high of 1576.09 on Oct. 11, 2007. Nine months later the S&P500 was down 23.36 percent. During that same period oil went from $83.08 to $147.27 – a return of more than 77 percent.

Nearby WTI prices did, however, dip to less than $34 in the midst of the 2008-2009 market meltdown, reflecting the clear relationship between recessions and collapsing oil prices.

But if you’re in the buying-opportunity camp right now, my sense is that WTI may offer more profit potential.

WTI is down almost 27 percent from a high of $114 reached in May, while Brent has dipped almost 12 percent from its high. Brent oil, via a fund such as The United States Brent Oil Fund (NYSEArca:BNO), has outperformed the numerous WTI funds, which makes me think WTI is where much of the upside movement in crude prices will come from.

The most crucial variable in choosing among competing ETFs is your time horizon, as the table below makes clear.

For investors looking to profit from a very short-term increase in crude oil, say, over the next week, the United States Oil Fund (NYSEArca: USO) offers a good choice. USO has an average daily dollar volume of $932 million, more than all of the other crude oil funds combined. It only invests in front-month WTI NYMEX contracts, which are the most responsive to very short-term movements in oil.

The iPath S&P GSCI Crude Oil Total Return Fund (NYSEArca:OIL), like USO, only has front-month exposure, but it does in an ETN structure, which means investors assume credit risk associated with the bank that issues the note, Barclays in the case of OIL. On the other hand, ETN allow investors to avoid K-1 tax forms associated with futures investing, which many consider to be something of a pain.

But beyond an ultra-short holding period like I suggested above, USO and OIL have the lowest returns over the past one and three months. Still, because both ETPs invest only in front-month contracts, it’s not hard to imagine the results being the exact opposite over very short trading time horizons.

The point is that returns of USO and OIL just get worse and worse the longer the holding period. That’s why investors need to look at different ETFs if they're in the oil market for the longer hall.

The challenge is finding funds that limit the effects of contango. Contango, to those not familiar with it, is the term used to describe when the prices of futures contracts become higher and higher with each successive monthly contract. Contango, means that fund managers keep rolling into more pricey contracts as they maintain exposure, which can significantly eat away at returns over time.

Luckily, the ETF market is full of funds that seek to limit the effects of contango and, among them, the PowerShares DB Oil Fund (NYSEArca:DBO) has performed the best.

DBO invests in the contract with the least amount of contango or the greatest amount of backwardation – the opposite condition of contango. In other words, backwardation is where spot prices in the physical are the highest, while prices in the futures market steadily decrease with each monthly contract moving into the future. Rolling exposure as a contract expires means picking up extra returns each time.

The Powershares DB Crude Oil Long ETN (NYSEArca: OLO) does the same, but in an ETN wrapper. ETNs, again, come with both the credit risk and tax advantages I mentioned, but they also eliminate tracking error associated with ETFs. OLO has just $12 million in assets under management compared to $530 million for DBO.

Apart from the Brent-focused BNO, returns among the different securities haven’t differed that much in the past three to six months. But over the past 12 months, DBO and OLO are the only funds to show a positive return.

The United States 12 Month Oil Fund (NYSEArca: USL), which spreads out exposure evenly over 12 months of futures, came in slightly behind DBO and OLO. The Teucrium WTI Crude Oil Fund (NYSEArca:CRUD) and the iPath Pure Beta Crude Oil ETN (NYSEArca:OLEM) have shown similar returns to USL, but haven’t been out a year yet, so it's difficult to draw too many conclusions.

Again, all of the funds like DBO that offer multi-month exposure have better performance than USO and OIL for a long-term holding period. Contango is just too big of a factor to overcome.

But don’t get me wrong:Front-month futures contract ETFs aren’t a bad investment. Investors just need to understand, in the case of oil, they make better short-term trading vehicles so that contango doesn’t have the time to ruin returns. Therefore, long-term oil investors are better off in a fund like DBO designed to limit the havoc contango can wreak on returns.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 IndexUniverse LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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