ETFs – exchange-traded funds – have been the rage for the investment world for the past half-decade. This is especially true when you consider the price of oil and the fact that it is the most vital, in-demand commodity in the world – bar none. So, when you marry the two concepts, you get crude oil etfs: some of the most popular and commonly-traded ETFs on the market today.
Whether you’re trading a long oil ETF, a short oil ETF, or some other variety, there are more issues with this particular type than there are with other ETFs on the market. Here, I’ll give you insight into what you need to know to successfully navigate this often-complex but always lucrative market.
What Are Crude Oil ETFs?
As with other types of ETFs – gold ETFs, stock ETFs, natural gas ETFs, you name it – a crude oil ETF is a fund that mimics the value of oil and can be traded openly on the market just like a stock. Before these came about, you’d have to either engage in futures contracts, buy and sell stock in an oil company, or actually purchase oil (something 99% of investors can’t or won’t do) to gain exposure to this commodity.
Now, though, you can find a wide range of ETFs that all have something to do with the value of oil as a global resource. You can buy long oil ETFs, which take bullish, optimistic views of the future value of oil, or short oil ETFs, which allow you to bet that the value of oil will drop. You can also buy leveraged oil ETFs that offer twice or triple the standard return if oil goes up or down. These are obviously riskier than standard, non-leveraged ETFs but can generate a much larger return.
Oil is predominantly used either for petrochemicals or for transportation, but it is also used in heating. There are actually heating oil ETFs that allow you to capitalize on oil’s portion of the energy market. One is the United States Heating Oil Fund (UHN) that uses future contracts for its value (more on that later). As you can imagine, this type is seasonal, spiking in the fall and winter when heating oil is needed.
In general, there are two ways crude oil ETFs are valued. Some are based on futures contracts, and the others are based on the spot price for oil (what the commodity is worth today, not next month) either because they own oil or produce it in some way.
I’ll compare futures-based oil ETFs with oil services ETFs to give you an example.
Futures-Based Oil ETFs
Some crude oil ETFs are valued based on futures contracts, or, an agreement to buy or sell something for future price (known as the strike price) and make payment at a future date. For example, you can buy a futures contract for 100 shares of an oil ETF at $50 per share and actually pay for the shares one month from now, when the value of the ETF is at $52. Since you only pay $50, you make a profit of $2 per share. People buy futures contracts when they think the value of something will go up in the future; they sell futures contracts when they think the value of something will go down. Unlike options, both parties to a futures contract are obligated to fulfill the terms of the contract.
Futures-based oil ETFs have the advantage of allowing you to proactively trade oil and get ahead of the market. Plus, they have the potential to generate bigger returns than indexed ETFs or physically-backed ETFs (ETFs that cover assets that actually own oil). This is accomplished through something called backwardation.
Backwardation is a condition in the market when the price of a futures contract is below the spot price – a.k.a. the current price – when the contract reaches its end. In other words, the expected future price for the contract is higher than what you can pay today for the same contract.
As the contract gets closer to the expiration date, the contract will trade at a higher price. I won’t get into the technical aspects of why this is here, but I’ll give you an example. Let’s say the price for an oil futures contract is $50, with a one-month expiration. By taking this contract, you’re promising to pay $50 one month from now. The market would be in backwardation if the expected price for the future contract one month from now is, say, $60. So, you will make a profit of $10 at the end of one month (minus fees, margin, and other related expenses).
When a commodity is in backwardation, generally speaking, the futures contract you buy today will increasingly be worth more money tomorrow and each day after until expiration. That is one reason why futures-based oil ETFs can generate more return than physically-backed ETFs.
Of course, there is another risk – a concept called contango. Contango is the opposite of backwardation. This is when the price of a futures contract is above the spot price for the contract when the contract reaches its end. In other words, the expected future price for the contract is lower than what you can pay today for the same contract.
If the price for that same futures-based oil ETF is $50, with a one-month expiration, the market would be in contango if, one month from now, the price is $40. When you pay that $50, you are “locking in” a price for a commodity. So, when you actually make payment on month from now, you are paying $50 for something worth $40.
Traders shouldn’t go long on commodities when they are in contango – which is precisely the risk of owning a futures-based oil contract.
Oil Services ETFs
Oil services ETFs are ETFs that are based on the value of companies that help to produce, process, and distribute oil. These companies make equipment and provide services that help to actually get the oil out of the ground, which means they do well when oil demand is up and prices are up.
One major advantage of an oil services ETF is that it insulates you from the volatility of oil itself. Oil’s price goes up and down on a regular basis and can spike dramatically. This same disadvantage is present with futures-based ETFs. By investing in companies, though, you can gain the benefit of having more stability and less volatility.
Another advantage is that oil services ETFs aren’t subject to contango and backwardation, so there is less risk involved. Plus, you can actually conduct research on the underlying companies to have a more informed trading opinion. This research could lead you to the realization that oil will be more difficult to obtain in the future, which means more business for oil services companies.
Of course, futures-based ETFs, while potentially more volatile, can generate larger returns. There is also something to be said for simplicity; involving corporations gives you more opportunity to research and make an informed decision but it adds complexity. With futures-based ETFs, you’re basically dealing solely with the current and expected price of oil.
Which is the best oil ETF for you? There are many choices – oil is one of the most traded commodities in the world – and each has its own advantages and disadvantages. Those with experience in the futures world and with a higher risk profile could turn to futures-based ETFs, like the United States 12 Month Oil (USL), a fund that rolls monthly contracts over each month. This is probably the most popular futures-based oil ETF on the market – and probably the most popular oil ETF in general. Another choice is the ProShares Ultra DJ-UBS Crude Oil (UCO), which is also a 2X-leveraged ETF. An inverse ETF option – one that bets the price of oil will go down over time – is ProShares UltraShort DJ-UBS Crude Oil ETF (SCO).
For oil services ETF, the most widely-traded one is the PowerShares Oil and Gas Services Portfolio (PXJ). You may also like the Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ), which is more focused than PXJ. Going short, your most popular option is the UltraShort Oil & Gas Fund (DUG).
Do your research and choose wisely. There are many options out there, and ultimately the best oil
ETF for you is one that matches your risk profile and knowledge of futures, the oil industry, and how the market operates.