Energy ETFs: The Tracking Problem

Hard Assets Investor submits:

By Charles Armstrong

For the average investor, the commodities markets can be daunting. Many investors don't possess the capital and/or risk tolerance necessary to invest directly in the futures markets. Further, although the number of online brokerages that offer futures trading is growing, for the most part, buying or selling commodity futures requires setting up a special account, which, for many retail investors, may be more trouble than it's worth.

Enter the commodity ETF.

Commodity ETFs are relatively new, but that hasn't stopped them from attracting investors-in 2009 alone, commodity exchange-traded products brought in $30.1 billion in new investment. Although some precious metals funds actually hold the goods in question-the SPDR Gold Trust (NYSE Arca: GLD), for example, actually keeps gold bars in a vault-this strategy is impossible for most commodities, whose worth is determined by their usefulness. As such, commodity ETFs purporting to track prices in other classes of good require some type of derivative investing; in the commodities world, that means futures contracts.

However, by their very nature, commodity ETFs allow investors to make longer-term bets on the value of a given commodity than is typical in the futures market. The futures trader makes money simply if the price of oil for delivery in a given month goes up between now and that month's contract expiration. But for the fund investor, who buys shares of an oil ETF expecting the price to rise over the next several months or years, the case is not so cut and dried.

As we've covered before , it comes back to the structure of the fund. If, for example, an ETF holds only the front-month contract for a given commodity, then that contract must be sold before its expiration, and the next (soon to be front-month) contract must be purchased in its place. Since the two contracts are almost certain to have some price discrepancy, the difference on this roll must be factored into the return of the fund.

What's more, a futures-based commodity ETF is part of a secondary market on top of the already volatile futures market. As investors buy and sell shares of what is essentially ownership of other financial instruments, the fund's value may fall out of whack with the commodity it is purporting to track. After all, demand for an ETF may be very different than demand for the futures contracts that ETF tracks: Just look at the U.S. Natural Gas Fund (NYSE Arca: UNG).

With these potential pitfalls in mind, let's compare the relationships between several energy commodity ETFs and the front-month prices of the commodities they purport to track. A regression analysis should help us get an understanding for how well (or poorly) a given ETF truly tracks a commodity.

Let's look at the funds with the highest trading volume in oil, natural gas and gasoline: the U.S. Oil Fund (NYSE Arca: USO); the U.S. Natural Gas Fund (NYSE Arca: UNG) and the U.S. Gasoline Fund (NYSE Arca: UGA). Each of these funds invests in the front-month contract only, reflecting the simple, long and unleveraged approach. All data is close of day from the fund's inception to 2/12/2010, as compared with equivalent sessions for each commodity.

Crude Oil: United States Oil Fund ( USO )

Launched: 04/10/2006

R_Squared: .7944

Beta: .84178

An R_squared of .7944 means that roughly 80% of USO's change in price can be attributed to its relationship with oil prices. If you consider the fund a proxy for buying oil directly, that is far too low a correlation to be seen as true investment in the commodity.

Looking at the graph, there's a near perfect straight line when the price of oil is above $80/barrel, indicating a tight correlation. However, at the lower end of the spectrum, two other trend lines have formed with very different trajectories. While analyzing each of these components is best saved for another time, we can generally conclude that USO is prone to erratic shifts off its intended link.

Natural Gas: United States Natural Gas Fund ( UNG )

Launched: 04/18/2007

R_Squared: .8053

Beta: 5.7965

Like USO, UNG's R_Squared of .8053 means that approximately 80% of UNG's price fluctuations come back to spot prices, which is low for a fund that does nothing but own natural gas futures. Sure, that line down the middle implies about as strong a correlation as you can get, but notice again that, as with the Crude Oil/USO comparison, there are outliers that seem to form lines of their own, implying that divergent trends, when they appear, follow unique correlations.

One important thing to notice here is the abnormally high beta. This does not mean that the price of UNG is more volatile than the price of natural gas, per se, but rather that the fund moves in bigger absolute values than does gas itself, although the percentage changes up and down are more or less equivalent. For example, when natural gas was at its four-year high of $13.50 in July of 2008, UNG shot up to $63.20-nearly a 12% increase for both UNG and natural gas' values compared with one month prior. So in other words, despite the high beta, their graphs follow a similar logarithmic trajectory.

Unleaded Gasoline: United States Gasoline Fund ( UGA )

Launched: 02/26/2008

R_Squared: .9837

Beta: 18.7292

The picture pretty much says it all. The UGA ETF, with an R_Squared of .9837, is about as close as one can possibly get to tracking the prices of unleaded gasoline. But it should be noted that the fund has only been in existence for about two years, and with that huge beta, it'll be worth keeping an eye on this fund's performance down the line.

Recently, U.S. Commodity Funds also introduced a line of 12-month funds designed to circumvent contango, and hopefully better track their underlying commodities. Essentially, the funds hold an equally weighted basket of 12 consecutive months' contracts; when the front month is about to expire, it is sold and the contract 13 months out is purchased. That means during each rollover period, only 1/12th of the fund's portfolio changes.

But do they work? Let's look at one such fund, the U.S. 12 Month Oil Fund (NYSE Arca: USL):

Crude Oil: United States 12 Month Oil Fund ( USL )

Launched: 12/6/2007

R_Squared: .9546

Beta: .5610

As the graph shows, USL clearly does a better job tracking crude oil prices than its cousin, USO. That's because futures chains, like the one in USL, tend to move synchronously over any given trading period, which averages price movements to be more in line with what the underlying commodity is doing. What's more, it factors out some of the volatility that occurs as the contracts are rolled each month.

As you can see, energy ETFs do a reasonable job of following their underlying commodities, but in several cases, big jumps from expected correlation do occur frequently enough to warrant strong caution. As such, it is perhaps best to consider the relationship one of strong correlation, but by no means proxy.

Keep in mind that this is just the tip of the iceberg. There are dozens more oil and gas ETFs, each with their own unique allocations and strategies for tracking the prices of their underlying commodities. The point of this article is not to say that one fund is good or another is bad, but rather to demonstrate the ways in which the funds may or may not diverge from the price of their underlying commodity.

Author's Disclosure: None

See also Hedging Against Cheaper Oil on

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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