You will probably have seen in the news yesterday morning (21st April 2020), that U.S. oil futures prices were negative. This is based off the May WTI Crude futures contract, which settled on 21st April in the U.S.
Due to the extreme supply glut and lack of demand for oil from a global shut down, the cost of storing oil is currently astronomical. Traders have been desperately trying to offload contracts before settlement to avoid taking physical delivery, which has caused negative oil futures prices for the first time in history.
We’ve had many investors ask what this means for our Crude Oil ETF (ASX: OOO) which aims to track and index which provides exposure to WTI futures. OOO’s index finished rolling into the June contract on 13th April, so will not be holding negatively priced May contracts. The June contract is currently trading at USD 20.72 (21st April, 08:39 AEST). Of course, the performance of the ETF will be impacted by the prevailing price of the June contract (e.g. it was trading at highs closer to USD 24 on 20th April). An equally important component of the performance of any Oil ETF which aims to track futures prices, though, is the impact of contango, which I provide more detail on below. It’s critical information for anyone interested in investing in or those who have already invested in Oil ETFs. I’ll use our OOO fund as the example, but the concept of contango and its impact on performance should apply to any futures based Oil ETF.
OOO provides exposure to front-month WTI Crude oil futures, and is therefore subject to the shape of the futures curve and the associated “roll-cost”. WTI futures contracts expire on the third business day prior to the 25th of the month and therefore need to be rolled to maintain exposure. OOO’s Index gradually rolls the current contract over a five day period commencing on the fifth business day of the month.
We are currently witnessing extreme conditions, with demand and supply-side shocks. As you can see in the chart and table below, the futures curve is currently very steep at the front end and this has shifted dramatically over the last few weeks (it was still in backwardation in January, however was as high as 27% per month in the days following the S&P GSCI Crude Oil Index rebalance ending 13th April).
Source: Bloomberg. Data as at 14th April 2020.
Source: CME. Data as at 15th April 2020. https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html
The premium of next month’s futures contracts will decay towards spot price as time moves towards expiry date. This is an unavoidable component of commodity futures. At the time of the screenshot above, the June contract is trading at USD 28.01. If the spot price of WTI stayed stable at the price at that time of ~USD 20.78, the June futures contract would have to erode 26% from then until expiry on 19th May 2020. This erosion would be represented by a fall in NAV by any oil ETFs which aim to track these contracts.
It is also important to note the increasing importance of this issue as prices drift lower. Even if in absolute dollar terms the premium remains the same, as a percentage (slope of the futures curve) this will increase the % roll cost for a front month futures program. The materiality of this number should not be underestimated.
That said, while last week’s OPEC+ cuts may have been insufficient to offset the current glut in oil caused by the demand impact of the COVID-19 pandemic, Energy remains a sector that’s critically important to any eventual recovery in global growth.
In a world where the risk of a return to the levels of production growth from U.S. shale producers of recent years appears to be mitigated by limitations on the access to capital and the potential for widespread bankruptcies, global energy markets could once again be the domain of energy’s Supermajors.
For investors looking to play a view on oil and the cyclical recovery, an alternative may be a Global Energy Companies ETF we have trading on the ASX under the code, FUEL (which provides exposure to the 50 largest energy companies globally ex-Australia). We believe a number of tailwinds are likely to emerge for the major energy companies. And, what’s more, these companies historically have a high correlation to the price of oil, with FUEL’s Index demonstrating a ~84% correlation of monthly returns with the Brent Crude Oil USD/bbl. since inception.
As at 22nd April 08:30 AEST, The June contract is now trading at USD 13.35.
Alistair - thank you, useful article. What collateral do OOO have to lodge with the exchanges ? Or do they trade on a give-up basis ?
What does this mean for OOO? Having a basic knowledge of ETF's and futures my understanding is that OOO will have to take physical ownership of the oil in June or pay someone to take the contracts off their hands (assuming the June futures follow May futures into negative territory). In either case: - The ETF is not prepared to take physical ownership with no where to store the oil; or - The ETF has paid to offload their underlying assets rendering the ETF worthless. I hope that I'm incorrect here but that's how I see it....what I'd like to know is, is there a real chance that this ETF could go broke? If anyone could offer their advice it would be greatly apprecaited! thanks
Alistair- on Apr 22 12:25 pm NAV is 2.097, JUne WTI Future $10,98 and Share Price $2,55. Let's assume WTI Dec future is $40 in October or x4 from now. Is it fair to expect the same ~x4 movement to NAV and SP ?
Interesting question Steve. I had a look at the PDS for OOO, and it seems the ETFs don't primarily invest in futures contracts directly on market. Instead they gain exposure through entering into swap agreements with financial institutions, which would avoid the risk of having to take physical delivery. See page 8 & 9 of the PDS: https://www.betashares.com.au/files/collateral/pds/QAG-OO...
Hi Michael, as Patrick mentioned OOO actually gains its exposure to the S&P GSCI Light Crude Index through a swap arrangement. The fund invests its assets in a basket of cash and money market instruments which are held in a segregated account by BetaShares' custodian. The swap is marked to market on a daily basis to a "zero exposure threshold", aiming to mitigate counterparty exposure to zero each day.
Hi Steve, in addition to Patrick's comment, OOO's index aims to roll from the the front futures contract into the next, well in advance of the settlement date to avoid physical delivery. During the roll period 7th - 13th May, the May contract was still trading positive. It is also important to note that investors in OOO cannot lose more than their initial investment.
Thank you for your great article. I get confused where you talk about the roll costs. I’m the example above if we close out June contract at $20 and make a 26 percent loss, do we “roll” and buy the July contract at the same time as we close June and at the same price? As of now June forward price is $11, therefore say you closed your June position now at $11 and made a big loss, looking at the screen you can not buy July futures at $11, meaning your roll entry price is a lot higher then your close price. Is this the cost of the roll you refer too?
Bruce, I'm pretty sure that means it can go to zero but not negative. It's marketing spin.
Alistair - many thanks for taking the time to respond. Presumably the MtM is bilateral with the swap provider so $ will flow both ways if you're in-the-money or out-of-the-money, which makes sense. Daniel - I suspect the answer will be, in part, the number of contracts they buy closing out one position and rolling to the next futures contract. Hopefully Alistair reverts on that aspect you've highlighted.
What exposure weighting does the ETF OOO have to WTI futures? The PDS only mentions the S&P GCSI index, no mention of futures. As others have asked I would also like to know the potential of OOO going to zero in the event of another month or two of negative futures value at the time of contract expiry.
By all accounts the safest way to play oil right now is through oil storage/tankers who's rates have sky rocketed. Scorpio Tankers is my pick. Demand side destruction will remain for some time to come due to Covid. A very volatile space buyer beware.
Hi Daniel, the index rolls over a five day period, moving from 100% in the first contract, reducing by 20% each day and moving that 20% into the next contract. Since the exposure is fully invested but not leveraged, when rolling, (assuming all else equal) the total dollar exposure will remain constant, but if the next contract is more expensive than the last, there will be exposure to fewer contracts. In your example, if the index rolled $100 million of June contracts priced at ~$11 (~9 million June contracts), into $100 million of the July contract priced at ~$18, it could only get exposure to ~5.5 million July contracts. The total exposure is still $100 million. However, if oil prices did not move, that July contract would likely erode towards spot price at the settlement date, which if we take this as remaining at $11 in this theoretical example, it would mean the total exposure reduced from $100 million to ~$61 million (5.5 million contracts x $11 contract price), a decline of ~39%. The roll yield is the difference between the movement of spot price and the futures contract. In this example spot price moved 0%, but futures decayed 39% from their initial premium. This represents a -39% roll yield or 39% cost of roll.
Hi Aaron, OOO aims to track the S&P GSCI Crude Oil index, hedged into AUD. The index includes WTI crude oil futures contracts with the nearest expiration date, which are rolled into the next month's contract according to a regular cycle. The Fund's investment exposure is obtained via a swap arrangement. The index roll period is prior to futures contract settlement and expiry to maximise liquidity and avoid physical settlement. In view of unprecedented market developments and to reduce the risk to the Fund of the June 2020 futures contract trading at a negative price, (which would reduce the Fund's value to zero), BetaShares has considered it in the best interest of unitholders, to temporarily replace its exposure to the one-month (currently June 2020) contract, with exposure to the three-month (currently September 2020) contract with immediate effect and until further notice.
Aaron - S&P/GSCI Light Crude Index - "....This index provides exposure to a basket of near-dated futures contracts on West Texas Intermediate benchmarked crude oil......." per the S&PDJ Indices website. There are some variations to this index (eg ER=Excess Returns) but presumably per Alistair's earlier response, this is the index OIL is tracking (down c. 80% YTD - ouch!).
Hi Alistair, thanks for the article and clarification on questions so far. For the swap entered into yesterday (23 Apr) to roll all June futures into Sep futures, what were the terms involved and was this arranged according to market conditions at 09:55 on 23 April (at time of announcement)? Asking this question because the NAV of each unit seems to have fallen much more than (the fall in June contract price overnight that night + price differential between the June and Sep futures at 09:55, 23 April) following the rollover. Also as spot price and June futures price both rose substantially overnight last night, the Sep futures has not moved much and NAV for the fund has even further reduced (at time of writing). Does the NAV take into account an estimation of all future rollover costs based on the futures price curve? Is there a way to get a breakdown of the NAV? In view of this, what's the potential future direction of the fund strategy? Would it perhaps roll the Sep futures to Oct futures? Or revert to July futures? TIA.
Are the fund's holdings posted daily like USO?