Oil investors are losing money. That shouldn’t surprise anyone, with the price of crude down by more than 10% so far this year, except perhaps for those who really believed Opec’s production cuts would make a difference this time.
Yet that is of course not the only way that oil investors are suffering losses. The nature of the exchange-traded products (ETPs) that are typically investors’ primary means of direct exposure to oil also costs them.
Users of these ETPs should by now be well aware that they rely on futures contracts linked to the oil price, rather tracking the oil price itself in a direct, linear fashion.
These futures contracts have to be renewed regularly to offer continuous exposure to oil: if the new contract being bought is more expensive than the one being sold, the investor suffers a loss; if the contract being bought is cheaper than the one being sold, the investor profits. The former situation is known as contango, and the latter backwardation.
There have been few attempts to quantify what this means in practice for investors, though, other than pointing to the difference between the performance of an ETP and the spot oil price. For example, many oil ETPs lag their index by a percentage point or more over the past year, which cannot be explained purely by their fees.
New research by Sung Je Byun, an economist at the Federal Reserve Bank of Dallas, may however shed greater light on the phenomenon.
Caught in contango
Byun observed that between the launch of the first oil ETP in April 2006 and the end of 2016, the market had been in contango far more often than in backwardation, with 92 months in the former environment to only 37 months in the latter. The opposite had been true of the period before that first ETP’s inception: from January 1996 to March 2006, contango prevailed in only 34 of the 123 months.
This prolonged contango has severely damaged investors’ returns. According to Byun’s calculations, since April 2006 the geometric average cost from rolling over the futures contracts has been 1.33% per month. On an annualised basis, that is a loss incurred by the ETPs of 14.88%, far in excess of the 2.69% annual loss through that period from weak oil prices.
Not so slick
If that seems impossibly large, remember that the oldest oil ETP – the United States Oil fund – has lost 86% since its launch in 2006, or almost 16% annually. The oil price has dropped by just 14% cumulatively, not annually, in that period. The ETP still holds over $3 billion (£2.3 billion) of assets.
To illustrate the point about the extent of these losses, Byun chose the experience of 8 January 2016 as an example. ‘If managers executed rollover transactions at the end of day, the ETFs would have sold the nearest-to-maturity contract at $33.16 per barrel while purchasing the contract that is next-to-nearest-to-maturity at $34.32 per barrel, resulting in a loss of $1.16 per barrel, or about 3% of the ETF’s value,’ he stated.
To compound the frustration for investors, oil ETPs have ceased to offer a diversification benefit in portfolios. Byun found that crude oil had a negative correlation of 0.02 to the S&P 500 between January 1996 and March 2006, but a positive correlation of 0.43 from April 2006 to December 2016.
‘The shift in performance suggests crude oil ETFs no longer provide a better investment opportunity than the S&P 500,’ Byun concluded, highlighting that a portfolio split evenly between oil and US equities had outperformed the S&P 500 in the 10 years before April 2006 but had trailed it in the subsequent decade. ‘In fact, one can show that any portfolio holding oil in positive amounts would be worse, in this sense, than holding the S&P 500 alone.’