|November 10, 2009-|
Question: Which single raw material has so far this year given a return to investors of 5.2%, 7.2%, 18.4%, 18.8%, 19.1%, 19.7%, 21.3%, 23.3%, 24.8%, 27.3% and 33.1%?
Answer: Oil, in the form of different exchange-traded products.
*based upon index return for period 31.12.08-15.04.09, then ETC return
What proportion of the underlying commodity’s spot price movement have the ETFs/ETCs therefore returned? Between 7% and 40%, it turns out. Here are the levels of the key oil market benchmarks on the same start and end dates and the percentage price change over the 10-month period.
And what’s the reason for the diversity of the ETC returns and the shortfall when compared to the spot price return? The shape of the oil futures curve and the contango that has prevailed in 2009 are the key factors (contango describes a futures curve when contracts with a later expiry date trade at a premium to nearer-term ones).
The chart below, provided by ETF Securities, shows how periods of contango and backwardation (the opposite state of affairs) have alternated since 1997. The y-axis gives the historical 12-month moving average roll yield between the front month and next month futures in the Brent Oil market. Between 1997 and 2008 this ranged from around -2% to +2.75% per month, or up to -21%/+38% on an annualised basis.
However, early in 2009 (beyond the x-axis scale of this chart), the oil market moved into what has been described as “super contango”. Next month NYMEX WTI crude oil traded at a record US$8 premium to the front month contract in both January and February this year, representing a massive 68% on an annualised basis, according to columnist John Kemp of Reuters. Although this premium shrank to around 7% by late October, contango has reigned all year.
The inability of the various oil trackers to achieve anything close to the spot price return in 2009 therefore reflects the painful reality of having had to reinvest at large premiums to the expiring contract, incurring significant negative roll yields as a result.
Not everyone has suffered from the super contango, however. Many trading companies and investment banks earned windfall profits early this year by leasing tankers, buying spot (near month) oil, taking delivery and selling the June contract. Supertanker rental rates jumped by 56% in the first three weeks of January, according to one source, as proprietary trading outfits fought with each other to secure storage facilities.
But since commodity ETFs and ETCs cannot take physical delivery of raw materials and are restricted to generating their market exposure through futures, what approach should they take?
Source’s launch last week of a new oil ETC – the Source S&P GSCI crude oil enhanced T-ETC – represents one attempt to get round the thorny problem of a steeply positive futures curve by rolling into longer-dated contracts when the premium at the front end of the curve (next month minus front month contracts) exceeds 0.5%, a situation that has prevailed for most of this year.
According to the back-tested S&P GSCI crude oil enhanced index returns given on the issuer’s website, this rolling methodology would have generated a return of 30.5% over the 10 months to end-October – much more than the basic S&P GSCI crude oil index’s 7.7% return, if still far short of the spot price increase over the period.
ETF Securities, on the other hand, provides a variety of oil ETCs offering exposure to different maturities on the futures curves of the two key market benchmarks, WTI crude and Brent, and allows investors to take their own views on the shapes of the respective curves.
According to MJ Lytle, head of marketing at Source, “We don’t believe that investors want to be forced to take a view on the shape of the oil market curve. Imagine the oil curve as a dog’s tail, with the near month as the tip of the tail. The near month tends to jump around and, although the longer maturities have moved up recently in price, they tend to be fairly static in comparison to spot prices. If you buy longer-dated oil products you have to take two views: one on the oil price and another on the shape of the futures curve.”
However, Lytle concedes that Source’s product is not a perfect oil market tracker. “We understand that there are contango issues. You can’t eliminate them, but you can mitigate them and at least get more of the oil market’s performance. If the curve returns to backwardation, our enhanced T-ETC becomes a front-month product and gives you the benefits of the positive roll yield. If it stays in contango, you go out to five or six months, which over the last five years has represented less of a cost in a contangoed environment than a front month product.”
Nicholas Brooks, head of research at ETF Securities, argues that investors need access to different parts of the oil futures market through tracker products. “Our ETCs offer exposures across the oil curve. Short maturity ETCs tend to track spot movements more closely and are more affected by contango and backwardation. Longer-dated futures tend to be driven more by long-term supply/demand considerations. Investors can themselves choose to switch between the longer and shorter-dated ETCs, depending on whether the curve is in contango or backwardation.”
“The issue with enhanced indices is that you don’t always know what you’re tracking, you’re reliant on back-tested models which may not work so well in the future, and there’s the potential for higher tracking error and costs from the more active trading that comes with trying to optimise exposures,” said Brooks.
Which method is better and for how long investors will have to battle the contango blues remain open to question. According to Reuters’ John Kemp, it may be index-tracking funds themselves that have pushed the oil futures curve into a predominantly upward slope.
“Between 1986 and 2004, the oil market traded in backwardation in 143 months compared with a contango in 82 months (a ratio of nearly 2:1),” Kemp wrote in June. “But since 2004 the market's ‘normal’ state has shifted to contango. Prices have traded in contango in 42 months and in backwardation in just 12 months. The most obvious explanation is the influence of the huge volume of investment money which has flowed into the market.”
Source’s Lytle, however, is bullish about the prospects for crude oil trackers, assuming that contango effects can be reduced. “There’s US$5.9 trillion in the European mutual funds industry. People are saying that they want to devote 5-10% of their assets to commodities, meaning a potential investment pool of US$250-500 billion. Of those commodities, oil and gold are the ones that investors want to focus on the most. But there’s still less than a 1% take-up of this total in the form of oil, largely because existing tracker vehicles are still imperfect.”