What it means
An exchange-traded fund, or ETF, is an investment fund whose units are listed on an exchange. Investors buy a unit through a broker, and the fund's value follows the assets or index it is designed to track.
An oil ETF is built to follow either the oil price itself or the performance of oil-related businesses. There are two main types.
Commodity-based funds buy futures contracts, which are agreements to buy oil at a set price on a future date, because holding physical oil would be impractical. Equity-based funds hold shares in companies that explore for, produce, refine or transport oil, and their results depend on company profits as well as the oil price.
Futures-based funds have a feature that surprises many investors, because futures contracts expire and the fund must regularly sell the contract that is about to expire and buy a later one, a process called rolling. If later contracts cost more than nearer ones, a situation known as contango, each roll costs money and the fund can lag the oil price.
If later contracts are cheaper, called backwardation, rolling can add to returns. Oil ETFs are used by investors who expect oil prices to rise, by funds that want to hedge exposure to energy costs, and by traders seeking short-term moves.
Some funds use leverage, meaning borrowing or derivatives, to magnify daily returns, and these can behave very differently over long periods. The fees are charged as an annual percentage of the fund's value and reduce returns.
Businesses with large fuel costs, such as airlines and transport firms, sometimes consider oil ETFs for a simple hedge, though they usually prefer direct futures or swaps for precision. Anyone using an oil ETF should read its documents to understand what it holds, how it rolls contracts and what risks it carries.
The oil price can be extremely volatile, so these funds are best seen as tools for short or medium-term views.
In practice
Real-world examples.
Example
An investor believes oil prices will rise over the next six months and buys units in an oil futures ETF for $10,000. She tracks the fund's price daily and sets a loss limit. She sells after four months when the price reaches her target.
Example
An airline's treasurer wants a quick, low-cost way to hedge part of its fuel bill and buys an oil ETF worth $2,000,000. The ETF rises when jet fuel prices rise, which offsets part of the extra fuel cost. She later replaces it with futures contracts for a closer match.
Example
A pension fund wants exposure to the energy sector and buys an ETF holding the shares of oil producers and service companies. The fund pays dividends and moves with company profits as well as the oil price. The trustees include it as part of a diversified energy allocation.
Formula
Calculation
Roll cost per month = (price of next contract - price of expiring contract) / price of expiring contract
A futures-based oil ETF sells an expiring contract at $70 and buys the next month's contract at $71.40. Roll cost = (71.40 - 70) / 70 = 1.40 / 70 = 2%. If this happened every month while the spot oil price stayed unchanged at $70, the fund's value would shrink by a factor of 1 / 1.02 each month. After 12 months the fund would be worth about 1 / 1.02^12 = 0.7885 of its starting value, a drag of roughly 21%.Case study
Seen in the real world.
Redwood Capital is a fictional investment firm used to illustrate the roll cost of an oil ETF. In this illustrative story, a portfolio manager bought a futures-based oil ETF at $50 a unit when spot oil was $70 a barrel. Over the next year, spot oil ended at the same $70, so she expected to break even.
The ETF fell to about $39.40 because futures contracts were in contango and every monthly roll cost about 2%. Her loss was (50 - 39.40) / 50 = 21.2%, even though the oil price had not changed. She had not looked at the shape of the futures curve before buying.
Redwood now requires its managers to check the futures curve and the fund's roll method before investing in any commodity ETF. The firm also uses shorter holding periods for futures-based funds and considers equity-based funds for longer views.
Watch out
Common mistakes.
- Assuming an oil ETF tracks the spot oil price exactly. Futures-based funds can differ widely because of roll costs and the shape of the futures curve.
- Holding leveraged oil ETFs for long periods. Daily resetting means the return over months can differ greatly from the expected multiple.
- Treating an equity-based oil fund as a pure oil price bet. Company shares also reflect costs, debt, management and market sentiment.
Questions
People also ask.
What is contango?
It is a market condition in which later futures contracts cost more than nearer ones, causing roll losses for funds that hold futures.
Do oil ETFs hold barrels of oil?
Generally no. They hold futures contracts, swaps or shares of oil companies.
Are oil ETFs suitable for long-term investing?
They suit some views, but futures-based funds can lose value over time through roll costs, so many investors use them for shorter periods.
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