Monday, August 12, 2013

The Effect of Oil Futures Markets on ETF Investors

By Tim Dulaney, PhD and Tim Husson, PhD

Barron's reporter Brendan Conway is reporting on a relatively rare phenomenon occurring in oil markets that is benefiting some passive investors.  Futures contracts for oil are generally more expensive as the time to expiration increases -- i.e. a contract expiring later is usually more expensive. The story goes that there are costs associated with storing oil and as a result the futures prices reflect the impact of these storage costs.

The current situation in the oil markets is the reverse: futures contracts are actually cheaper than the spot price.  In this case, demand for immediate delivery of physical oil is offsetting the cost of storage making the spot price for oil exceed the price of short-term futures contracts.

Why should investors care?  Well, the way investors gain exposure to the oil markets (beyond at the gas pump) is through investing in futures-based ETFs.  These ETFs gain exposure to commodities by investing in futures contracts.  When the contracts approach expiration, the ETF sells their current holdings and buys futures contracts again.  If later dated futures contracts cost more than shorter dated contracts, then investors are selling cheaper contracts for more expensive contracts.  We explain this effect (negative roll-yield) in detail within a few of our research papers (PDFs).

The current situation is a little different.  Since futures prices are actually lower than the spot price, some ETFs are reaping the benefit of selling more expensive contracts and buying less expensive contracts when rolling over their holdings.

Although investors with holdings in futures-based oil ETFs (e.g. USO) are benefiting from this rare situation, they shouldn't expect it to last.  As demand for immediate delivery decreases, the markets will likely return to the more common state where later dated futures contracts are more expensive.  In this state, futures-based ETF investors will once again be exposed to the detrimental effects of negative roll-yield.

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