The 5-Minute Guide to Oil ETFs2015-06-24
The world still largely runs on crude oil. Its ever-present demand, coupled with erratic shifts in supply, makes it a volatile liquid and a popular instrument for investors, traders, and speculators alike. Savvy individuals have always had the option to play oil prices through the equities of multinational energy companies and/or smaller independent exploration and production (E&P) companies, as well as via actual oil futures themselves.
These instruments have notable drawbacks, though, including imperfect correlation to actual oil prices (for the energy company stocks) and high margin requirements (for oil futures). Enter oil ETFs. These products offer many of the advantages of direct investment in oil but in a vehicle that is much more convenient for the average individual investor.
What’s Your Objective?
Energy and oil ETFs can be broadly organized by the stated objective of the fund manager. Some funds are built to track a broader commodity index, of which energy may be a large component. Other funds focus exclusively on energy, but look for a broader approach by combining crude oil, natural gas, heating oil, and gasoline futures into the mix. Last but not least are those funds that commit themselves exclusively to a single asset.
West Texas Intermediate (WTI) is the most common benchmark for oil ETFs. WTI is the benchmark for the NYMEX oil futures contract and the most commonly used oil benchmark in the financial markets (in terms of trading volume). When the financial news (at least in North America) mentions the price of oil, they are almost exclusively referring to WTI [see also Crude Oil Guide: Brent Vs. WTI, What’s The Difference?].
While WTI is the benchmark of choice in North America, Brent crude is actually more common around the world. Not only is Brent the benchmark for oil futures in London, but most oil and fuel contracts in Europe, Africa, and the Mideast are benchmarked to this version of crude.
Mind the Structure
Prospective oil ETF investors also need to pay attention to the structure of the investment they are considering. Which contracts a fund buys, and how often the manager has to turn them over, impacts not only the performance of the fund (trading costs money), but also alters the price exposure and correlation.
The U.S. Oil Fund (USO), the largest and most liquid oil ETF, largely uses front-month contracts. This makes the fund more effective at capturing short-term moves but it reduces long-term efficiency. In contrast to indexes that roll their exposure to the corresponding futures contract on a monthly basis in accordance with a predetermined roll schedule, Pure Beta Crude (OLEM) may roll into one of a number of futures contracts with varying expiration dates, as selected using the Barclays Capital Pure Beta Series 2 Methodology.
It is also important to note the difference between ETFs and exchange-traded notes (ETNs) like the iPath S&P GSCI Crude Oil Total Return Index ETN (OIL). ETNs are unsecured debt securities issued by an underwriting bank and basically represent a promise on the part of the bank to pay the returns of the stated index (minus fees). ETNs can offer better tax efficiency and less tracking error, but they include credit risk that isn’t present with ETFs.
The Names to Know
As mentioned, the U.S. Oil Fund is the largest and most liquid oil ETF trading on U.S. exchanges. USO uses futures, options, and forward contracts to track NYMEX oil futures, focusing on front-month contracts while maintaining a 0.45% expense ratio.
The PowerShares DB Oil Fund (DBO) is one of the largest pure oil funds in terms of assets under management. Less than half the size of USO and much less liquid, DBO offers a higher expense ratio of 0.78%. Like USO, DBO achieves returns more closely correlated with spot oil price performance.
As mentioned before, Pure Beta Crude takes a different approach to its portfolio and may roll into one of a number of futures contracts with varying expiration dates, as selected using the Barclays Capital Pure Beta Series 2 Methodology. OLEM is a small fund but worth taking a look given its comparable expense ratio.
The iPath S&P GSCI Crude Oil Total Return Index ETN is the largest oil-related ETN on the market. The returns for OIL include a Treasury bill rate of interest on funds committed, which admittedly does not amount to much in today’s low-rate environment, while expenses fall towards the higher end at 0.75%.
Last but not least is the U.S. 12-Month Oil ETF (USL). USL invests equal amounts of money in the next 12 consecutive months of WTI NYMEX oil futures contracts, giving investors an even exposure to near-term and intermediate-term oil prices. This ETF is rather small but has a high expense ratio of 0.88%.
The United States Brent Oil Fund (BNO) is one of the very few available plays on Brent crude oil futures trading on the ICE Futures Exchange. BNO is small but liquid. The expense ratio of 0.90% is on the higher end of the scale, and the fund’s holdings are concentrated on front-month contracts.
Alternatives Worth Knowing
While the aforementioned ETFs and ETN are relatively “vanilla”, there are some riskier alternatives for investors and traders to consider.
The U.S. Short Oil Fund (DNO) is designed to deliver the inverse return of the front-month WTI crude oil contract. This is a very small fund but the PowerShares DB Crude Oil Short ETN (SZO) is scarcely larger. Nevertheless, they do offer a way to play falling oil prices outside of shorting shares like USO (and paying the borrowing costs).
Investors looking for even more risk and volatility can consider leveraged ETFs. ProShares Ultra DJ-UBS Crude Oil (UCO) offers daily returns of 2x the Dow Jones-UBS Crude Oil Sub-Index, while PowerShares DB Crude Oil Double Short ETN (DTO) offers double leverage in the opposite direction, as does the ProShares UltraShort DJ-UBS Crude Oil (SCO) ETF, though DTO also includes a T-bill return component. These highly leveraged funds are not intended as long-term vehicles – not only are they not especially tax efficient, but the daily re-balancing of some of these funds creates meaningful volatility drag. Note that PowerShares’ products, such as DTO, use a monthly reset to minimize volatility drag, but nevertheless it is still a fund designed for active traders and investors.
The Bottom Line
ETFs and ETNs offer investors a wealth of choices for executing their particular vision and outlook for crude oil prices. What’s more, they offer investors considerable convenience when it comes to margins, commissions, and tax reporting compared to similar futures positions. Though investors pay for this convenience in the form of fund expenses, oil ETFs are a valid and practical way for traders to add crude exposure to their portfolios or execute crude-focused trading strategies.
Disclosure: No positions at time of writing.