Oil has been on a roller coaster ride in the last 24 months. Australian investors can use Oil futures or a Oil ETF to take a position on Oil.
BetaShares Crude Oil ETF (OOO ETF) invest in oil futures directly and hedges the currency exposure of the total face value. OOO tracks the Standard and Poors’ GSCI Crude Oil Index which is an index made up of multiple futures contracts of the same commodity. Similar to equity indexes like the all ords the weighting in fund mirrors the respective weighting in the index.
Different crude oil benchmarks
The crude oil index primarily comprise of West Texas Intermediate (WTI) Crude Oil futures contract. There are a number of oil benchmarks representing the major producers in each region.
WTI represent the crude oil benchmark for oil produced in the United States. Another commonly quoted oil contract is called the Brent Crude Oil which represent oil produced in the North Sea.
The advantage of using ETF rather than oil futures directly is the greater flexibility in managing the position in the portfolio. Betashares charges 0.69% management fee per annum
In the instance of commodity future contract, each contract holds fixed number of commodities. Usually the units per contract is too large for retail investors and can increase difficulty in having the appropriate position within the portfolio.
Exchange trade funds like OOO ETF allows investors to manage the position to the dollar within the portfolio. The FX exposure of the Oil ETF is also hedged so Australian investors using on OOO ETF is effectively exposed to the AUD Forward Oil Curve.
What is an oil forward curve?
As with any commodity there is a spot price and a forward curve. The fund owns a number of futures contacts weighted based on world production and rebalanced annually in January.
Theoretically commodity futures are based on the spot price plus the storage and carry cost but the market expectation of future supply and demand plays a big role too.
One risk from exposure to future contract is the negative roll (negative carry) when the futures is priced higher than the current spot prices and as the future matures, the buyer rolls their position by selling the front month contract and purchase the future dated contract.
The return from rolling the future contract is positive when the commodity curve in backwardation (future prices lower than spot price).
Distributions from OOO are limited because future contract has no yield unlike dividend paying ETF which invests in stocks which has earnings and payout dividends.
Risks investing in oil futures
It is important to note that oil unlike base metals (copper and nickle) or iron is a much higher risk and volatile commodity. This is because the supply and demand balance for the oil market is precarious at the best of times and any disruptions from supply shocks (oil shocks) or demand shocks (coronavirus) will multiply the volatility in the markets.
What is a leveraged oil ETF?
There are leveraged oil ETFs listed in the US but not in Australia. These ETF takes the futures position but at 2x or 3x total gross position to the value of equity in the fund.
Why did oil future prices go negative?
As mentioned above there is no one oil price but different prices at various point in the future. The easiest explanation to why the oil price fell below zero is due to the number of holders closing their contract positions significantly outweighing the physical buyers.
It is important to remember commodity futures were invested to allow producers and buyers to hedge their risk rather than financial speculation. The key feature of commodity future is unlike equity indexes which are cash settled instruments, commodity futures are a physically settled.
Physical vs Financial Futures Settlement
Cash settlement means at settlement the buyer and sellers settle the differences between the settlement price and the price they paid the contract with cash.
Physical settlement is when those who are holding the contract on the expiration date is obligated to take delivery of the commodity.
Only those who can take physical delivery of the oil at expiration were willing buyers and given the weak demand leading up to the contract expiration date there were limited storage capacity left.
The negative oil price indicates sellers are willing to sell these contract at negative prices to remove the obligation which they cant fulfill at any cost.