oil

Contango Risks in a Popular Oil ETF Play

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As energy prices rebound, commodity traders have jumped on oil exchange traded funds to ride the rally from 13-year lows. However, long-term investors should understand that these ETFs track the futures market and come with specific risks.

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For instance, many have turned to the U.S. Oil Fund (USO), which tracks West Texas Intermediate crude oil futures, to play the turn in the energy market. USO is the largest and most popular oil-related ETF option on the market, with $3.6 billion in assets and 33.6 million shares changing hands daily.

However, oil traders should be aware that USO's underlying portfolio includes front-month WTI future contracts and the oil futures market is currently in a state of contango. Consequently, USO could experience a negative roll yield when rolling a maturing futures contract for next month's contract.

Contango occurs when the price on a futures contract is higher than the expected future spot price, which creates the upward sloping curve on future commodity prices over time. Essentially, the phenomenon reflects a current spot price that is lower than the futures price. For instance, WTI futures were trading around $46.44 per barrel Thursday for June 2016 delivery, but contracts with a later delivery are trading higher, with contracts for June 2017 delivery at $49.85 per barrel.

The futures market may diverge from the spot price due to a number of factors, including storage costs, carry costs and seasonal patterns, among others. Consequently, oil ETF investors would be exposed to the intricacies of the futures market, which may not perfectly reflect the spot price return of the underlying energy commodity.

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While this phenomena is normal in the futures market, contango can have a negative effect on ETFs. ETFs that hold futures contracts sell the contracts before they mature to avoid physical delivery and purchase a later-dated contract. In a contangoed market, the ETF loses money each time it rolls contracts to a costlier later-dated contract – the fund would technically sell low and buy high each time.

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Consequently, long-term investors may notice underperformance to the oil market since the ETF holds front-month contracts and would see a slight cost when rolling each front-month contract.

Contango has contributed to the long-term underperformance in a futures-backed oil ETF compared to West Texas Intermediate crude oil spot price. Over the past five years, WTI crude oil spot price has declined 55.6%, whereas USO decreased 71.0%.

Consequently, it would be in the best interest of a futures-based ETF investor to limit the negative effects of contango and profit off backwardation as the ETFs roll contracts set to expire for a later-dated contract. To limit the negative effects of contango, investors may consider investing in futures-backed commodity ETFs with longer-dated contracts.

For instance, the PowerShares DB Oil Fund (DBO) and United States 12 Month Oil Fund (USL) provide exposure to WTI oil but include a different weighting methodology to limit the negative effects of contango. DBO can include contracts as far out as 13 months and dump contracts at any point to maximize gains or minimize losses associated with the implied roll yield. USL, on the other hand, ladders 12 months of contracts to better control for backwardation and contango.

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The laddered approach has helped USL outperform USO over the long-term or at least perform less poorly. USL has shown an average annualized return of -16.3% over the past five years, whereas USO returned an average -22.0%.

However, since DBO and USL may both include contracts with longer maturities, the ETFs could be less sensitive to short-term swings in the spot price than USO. For instance, DBO and USL have underperformed USO during the recent recovery of WTI prices.

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