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The Wrong Way To Invest In Oil
Posted in Investment Strategy on 2016-03-17

Hedgewise can intelligently manage your oil investments for you at a low fee and with zero commissions.

Introduction: The Trouble With Oil Investments

With interest rates near all-time lows, and stocks likely approaching the end of a decade-long bull market, many investors are wisely considering oil as an alternative. The logic is quite intuitive: oil prices have fallen to their lowest levels in over a decade, and while it may be impossible to tell exactly when they will recover, there is a pretty good chance that they will eventually.

Yet it is incredibly difficult to execute on this simple idea because most instruments that provide exposure to oil are riddled with holding costs or tracking error. One of the most popular oil ETFs, the United States Oil Fund (USO), often suffers from paying high premiums on futures contracts (called "contango"), which has cost investors in the range of 10% to 80% per year. Investing directly in broad energy ETFs, like the Energy Select Sector SPDR (XLE), may seem like a reasonable alternative, but these products often fail to track the spot price of oil very closely. For example, in 2008, when oil prices went up 110%, XLE was only up 41%, or a difference of 69%.

In this guide, we'll provide a deep exploration of the root of these problems, and how they affect each of the most popular energy ETFs in the marketplace. You'll discover:

  • How oil futures contracts work, and why this can result in systematic underperformance over time
  • Why broad energy ETFs, like XLE, so often fail to keep up with oil rallies
  • Why alternatives like the iShares Dow Jones US Oil & Gas Exp. (IEO) do no better

The Oil Futures Market

The most direct way to invest in oil, besides literally buying a barrel of it, is with something called an oil "futures contract", which commits you to buying oil at an agreed upon price at some point in the future. Unfortunate ly, much of the time there is a premium on the price of oil futures, called "contango", due to speculation and to account for the costs of storing oil over time. For example, say the current spot price of oil was $50, and you could buy a futures contract for next month at $55. If the price of oil were to stay exactly flat for the next month, you would probably lose about $5 on that contract. If this were to keep happening, you would lose about 10% per month for the entire year!

This is often referred to as the "roll cost", and it plays a very significant part in your expected performance over time.

How This Applies to Oil Futures ETFs

The effect of this problem can be seen by examining the performance of ETFs that specialize in trading oil futures contracts. For example, USO has a policy of rolling over the nearest oil futures contract every month. This results in significant cost whenever the market is in contango, explaining its underperformance over time.

The iPath S&P GSCI Crude Oil Total Return ETN (OIL) and the United States 12 Month Oil Fund ETF (USL) are affected in a similar way. Note that data for all three ETFs has only been available since December 2007.

Performance of USO, OIL, and USL vs. WTI Oil Spot Price, December 2007 to March 2016

Source: EIA, Yahoo Finance

You might notice that USL has performed the best. This is because USL invests in 12 different futures contracts at all times, while OIL and USO only invest in the futures contract of the nearest month. This has helped to avoid some of the dramatic costs of trading futures in periods of heavy speculation, when the near month contract is often the most expensive. Even so, USL will still suffer from periods of underperformance, as it did from 2010 through 2014.

That said, the relative performance of USL provides an important insight. Since different oil futures contracts trade at different prices, there is an opportunity to pick the cheapest one at any point in time. This is the mandate of the PowerShares DB Oil Fund ETF (DBO), and, in theory, should lead to improved performance. Unfortunately, in practice, it has not.

Performance of DBO and USL vs. WTI Oil Spot Price, December 2007 to March 2016

Source: EIA, Yahoo Finance

The main reason that DBO has failed to outperform USL is because of the consistency of the futures curve. It is often upward sloping over time, such that the adjusted cost is about the same no matter which contract you buy.

It is helpful to zoom in on different time periods to get a better sense of how this works. You might have already observed how well DBO and USL performed from January 2008 to January 2009. We can examine the futures curve over that time period to understand why this was possible. Note that a "2 Month Oil Futures" contract is one that expires 2 months from today, and a "4 Month Oil Futures" contract is one that expires 4 months from today. If the "4 Month" price is higher than the "2 Month" price, this indicates that the market is in contango.

WTI Oil Spot Price vs. 2 Month and 4 Month Futures Contract Prices, January 2008 to January 2009

Source: EIA, Yahoo Finance

The important observation is how close the prices of both futures contracts were to the spot price over this entire period. In fact, at some points, the prices of the futures contracts were actually below the spot price, which is a case of "backwardation". This allowed USL and DBO to outperform. However, this trend changed dramatically in 2010.

WTI Oil Spot Price vs. 2 Month and 4 Month Futures Contract Prices, January 2010 to January 2011

Source: EIA, Yahoo Finance

Here, the futures curve was upward sloping, with the price of the 4 Month contract consistently above that of the 2 Month contract. As a result, all of the ETFs involved in trading oil futures suffered.

This demonstrates the general point that if you are going to get oil exposure using futures (whether directly or via ETFs), you need to be constantly monitoring the futures curve and adjusting accordingly. When the curve is upward sloping, trading futures will cost a hefty sum over the long term. Unfortunately, this will be the case for a majority of the time due to various structural reasons. Thus, it is necessary to identify alternative ways to get oil exposure, such as ETFs that invest directly in oil-related companies.

Unfortunately, you'll find that this can be equally frustrating.

Investing Directly in Energy-Related ETFs

While the most obvious candidates for direct investing are the numerous energy-related ETFs in the marketplace, a quick look at their long-term performance raises some concerns. Here's a look at a few of the most popular: the Energy Select Sector SPDR Fund (XLE), the iShares US Oil & Gas Explore & Production ETF (IEO), and the SPDR S&P Oil & Gas Explore & Production ETF (XOP).

Performance of XLE, IEO, and XOP vs. WTI Oil Spot, June 2006 to March 2016

Source: EIA, Yahoo Finance

The immediate reaction to this chart is often positive because it appears that all of these stocks have outperformed oil over time. While this is true, it also highlights that the companies held by these ETFs are being influenced by many factors besides the spot price of oil; otherwise, why would there be such a great deal of deviation from the curve? While this deviation may be positive over certain periods, it can just as easily be negative over others. One of the most salient examples of this downside risk occurred during the significant oil turnaround from 2007 to 2008.

Performance of XLE, IEO, and XOP vs. WTI Oil Spot, June 2006 to February 2007

Source: EIA, Yahoo Finance

Oil prices went down by around 20% from the summer of 2006 through 2007, yet none of these energy ETFs experienced the same dip. Before you celebrate, consider the implication: if the ETFs avoided losing money as oil prices sank, why would they be expected to make money upon a recovery?

This danger manifested soon after, as all of these ETFs failed to keep up with oil's rally over the following year.

Performance of XLE, IEO, and XOP vs. WTI Oil Spot, June 2007 to June 2008

Source: EIA, Yahoo Finance

Fast forward to today, and these ETFs are again outperforming the recent oil crash. With that in mind, they hardly seem like a great bet for taking advantage of any recovery. As a matter of fact, since the most recent oil bottom in early February, all of these ETFs have been underperforming.

Performance of XLE, IEO, and XOP vs. WTI Oil Spot, February 11, 2016 to March 17, 2016

Source: EIA, Yahoo Finance

Why Is This Happening?

The nature of this tracking error can be traced back to the fundamentals of the oil industry, which can be split into six different sectors:

  • Independent
  • Major Integrated
  • Drilling & Exploration
  • Refining & Marketing
  • Pipelines
  • Service & Equipment

As you might immediately guess, some of these sectors have very little to do with the actual price of oil. For example, if you run a gas station, you receive a small mark-up on the price of oil after buying it wholesale, but your profits are actually far more dependent on sales of snacks and beverages. Because refineries use crude oil as an input to produce gasoline or heating oil, lower oil prices may actually lead to higher profits, rather than vice versa.

Very broad energy ETFs, like XLE, naturally span across all of these sectors without intelligently accounting for such dynamics. As a result, their monthly performance will usually have a very loose correlation to the spot price of oil. For example, since late 2009, the Refining & Marketing sector has rallied even as oil prices collapsed. This has also buoyed the price of ETFs like XLE.

Performance of XLE and Refining & Marketing Sector vs. WTI Oil Spot, August 2009 to March 2016

Source: EIA, Yahoo Finance

While this sector outperformed while oil was crashing, it is now underperforming as oil rallies back. This is one of the primary drivers of the recent underperformance of XLE.

More tailored ETFs, like IEO and XOP, should theoretically avoid this problem by focusing on Drilling & Exploration. XOP primarily invests in smaller sized owner-operators of oil fields ("Independents"), while IEO skews towards larger, "Major Integrated" companies. Unfortunately, both of these methods still fail for different reasons.

Performance of XOP and Independent Sector vs. WTI Oil Spot, January 2012 to March 2016

Source: EIA, Yahoo Finance

While XOP most closely aligns with the performance of the Independent sector, these small companies are hugely susceptible to swings due to idiosyncratic factors, like their recent discoveries and the prospects for their particular oil fields. They are also far more susceptible to bankruptcy when oil prices fall quickly. These factors inject an element of pure randomness to long-term performance and make such stocks difficult to rely on.

Performance of IEO and Major Integrated Sector vs. WTI Oil Spot, January 2012 to March 2016

Source: EIA, Yahoo Finance

Since IEO holds larger companies, it most closely aligns with the Major Integrated Sector, in which firms are vertically integrated across many types of business. Though IEO attempts to 'tilt' its holdings towards firms with a heavier reliance on Drilling & Exploration, this has clearly had very little impact on overall performance. It falls victim to the same distortions present in XLE, with both ETFs often holding many of the same companies.

Conclusion: Is There A Better Solution?

It is fairly incredible that most investors still use either oil futures or broad-energy ETFs despite these problems. In the futures market, you are often fighting against a monthly cost drag as high as 10%, which makes it nearly impossible to invest for more than a few weeks. With broader ETFs, there is a huge element of randomness due to issues within the different oil sectors. Shouldn't there be a more elegant solution for such a basic investment goal?

The reality is that the ETF market is still relatively young and that most funds rely on relatively simple, generic indices. As the industry is maturing, it is becoming more obvious where such simple methods are not nearly sufficient. However, a growing amount of research suggests that there are indeed better solutions. For example, this method of building your own portfolio of oil companies has drastically outperformed all of the funds discussed in this article. While there will never be a "perfect" oil investment vehicle, these types of innovations show that there is plenty of room for improvement, and it may be only a matter of time until new standards begin to emerge.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

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