Scott Burns: Riding the oil wave with commodities-based exchange-traded funds. Hi there. I'm Scott Burns, director of ETF research with Morningstar. Joining me today is Abraham Bailin. He is an ETF analyst on our team. He specializes in commodity ETFs. Abe, thanks for joining me.
Abraham Bailin: Thanks for having me.
Burns: So, Abe, oil prices are all in the news. A lot of people are coming up to us asking about $200 oil, $250 oil. Before we start talking about the individual products, let's talk about the shape of the curve. Because really it's important for investors to know that when you're buying some of these commodities-based ETFs, you're not actually holding spot, you're holding futures-linked. Which means you got to understand the futures curve before you even start looking to invest.
Bailin: Sure, absolutely Scott. You know the thing is that when you're buying a futures contract, you're really not buying spot, and there's a number of other price pressures that come into play. This includes future expectations, which have been pumped up a little bit by recent events, and carry costs and things of the like. So, some investors have gotten burned in the past thinking that they're owning the spot commodity, but there is a number of pricing decouplings that can come into play.
Burns: So, when we look at the shape of this curve, and we'll talk about some of the different products in there, what are we looking at right now? The term "contango" is out there, and for folks that are watching this and not familiar with terms like contango and backwardation, we've written quite a few articles. They should find the link to those articles on the site here. So, we'll just proceed. What's contango looking like right now? What's the curve shape looking like right now?
Bailin: Right now front month is about $105, and then as we go out along the front end of the curve, that is to say, the futures contracts that are nearest expiration, out to about September or October, we have progressively more expensive futures contracts. Again, for those of you that are familiar with contango, you'll understand that as you roll your exposure from the near-to-expire contract into a later one, if you're selling for low and buying for high, you stand to take a loss.
Burns: So, we have what we know as negative roll yield right now, and actually, what kind of percentage negative roll yield are we looking at right now?
Bailin: Well, we're looking out to September and October. We're looking at prices getting up to about $107 in change over obviously front-month oil right now, which is $105.
Burns: So, kind of expect on a monthly basis a $2 loss just from the roll yield?
Bailin: Now, you also have to consider that there are a number of contracts between now and September and October. So, as you participate closer to September and October where the curve starts to flatten out, if you're rolling on a one-month basis and not holding all the way to expiration, you could damp those contango-related losses. But if you were to hold from say September and October and nothing changed along the curve and you held it until expiration, certainly you stand to take a significant loss.
Burns: All right, well, now that we've talked about the curve, and contango has steepened quite a bit. Let's talk about some of the various commodity-based ETF products that are out there. I think the first-generation product is United States Oil, which as I often remind people, does not actually hold physical oil. But, talk about that product right now, such as how it's structured and what kind of the shape of the yield curve can do to expected returns?
Bailin: Sure. Well, USO, like you mentioned, is a first-generation commodity futures-based ETF, and by that we refer to the fact that these types of funds hold the front-month futures contract. And as they approach expiration, they roll into the next month out. The very front of the futures curve is where you're going to see the highest sensitivity to movements in spot price, and along with that you are also likely to see the highest levels of contango.
Burns: So a good on one hand, but a bad on the other.
Bailin: Sure. So, the good hand is that you can really capture the sensitivities of the underlying. On the downside, these funds don't have very flexible methodologies. And so as they roll from the first month and to the next month's exposure, on a consistent basis, if the shape of that curve stays in contango, you can take losses.
Burns: Right. So, as oil is really kind of climbed up over $100 a barrel here, how has USO performed during that period relative to the spot price?
Bailin: Well, USO has really underperformed, and not only some of the equity-based funds and spot oil, but it's also underperformed some of the later-generation futures-based ETFs.
Burns: All right. So, let's talk about that. So, we've moved from USO to some second-generation or third-generation product. How about the second-generation products? What do those look like?
Bailin: So, in response to this nagging and persistent problem of contango, the same provider, United States Commodity Funds, came out with USL. USL was the sister fund to USO, and really what it does is, it takes its pool of assets and ladders them out along 12 months worth of contracts. By doing that, you mitigate an outsized exposure to that negative roll yield on the front end of the curve.
Burns: How has that performed vis-a-vis what USO has done?
Bailin: Slightly better that USO.
Burns: Slightly better, all right. Well, let's get to third-generation here. We're looking for close to spot now.
Bailin: So, really the product that came out gangbusters here and really shook up the game was PowerShares DB Oil Fund, ticker on that is DBO. There's no active management, but it uses a quantitatively-based, yet very dynamic, methodology to gain its futures-based exposure.
Burns: Okay and how has that performed?
Bailin: That's performed the best of the three.
Burns: The best of the three. How is your tracking against spot?
Bailin: You know, it hasn't quite held up to spot based on the fact that even though the fund allows itself the ability to position its assets along the curve at different points month-over-month, it still suffered a bit of those nagging problems. But not to anywhere near as grave an extent as the very immobile USO and first-generation funds.
Burns: Right. So among these different kind of commodity structures that we talked about today, if an investor says, "I think oil is going to $200 or $150" for whatever reason, what's our current pick right now for what they should be looking at?
Bailin: Well, there are a couple of options. DBO is good all-round option, it's going to give you downside protection. It's going to protect you against those outside contango-related losses, and on a month-over-month basis it has the flexibility to move into the most lucrative contracts. If you see oil going up drastically, USO will serve just fine, but again you don't necessarily have that downside protection.
Burns: All right. Well, thanks for joining us. It's definitely complex. We always say, "Investors, you need to know what you own; know what you own." We have a lot of research on these commodity funds, and there are a lot of different ways to kind of play this.
Burns: Thanks for being here.
Burns: I am Scott Burns for this and other ETF information please check out morningstar.com's ETF Center at Morningstar's ETFInvestor Newsletter.