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Guide to Oil Commodity ETFs

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The energy sector, in particular oil, has caught investors’ attention for most of this year. Thanks to encouraging economic trends across the globe and geopolitical tensions, oil prices have been trading comfortably above the triple-digit mark. The favorable demand/supply dynamics is also supporting oil price increases (read: Uprising in Iraq Puts These Oil ETFs in Focus).

Demand/Supply Trends

Economic activity in the world’s largest oil consumer picked up strongly after freezing temperatures, housing market started showing signs of improvement, and the job market accelerated with the strongest growth seen last month since the technology boom in late 1990. The improving health of the economy will prompt further demand for oil in the coming months.

As per the International Energy Agency (IEA), global oil demand would rise a modest 1.5% to 92.8 million billion per day this year. Most of the demand is expected to come from emerging countries like India and China. Notably, the demand for oil in the U.S. has outpaced China in 2013 in 15 years (read: 3 Top Performing Emerging Market ETFs).

The growing demand will likely be met by booming oil production in the U.S. where output reached its highest level in 28 years on shale formations, and newly tapped oil and gas fields in North Dakota and Texas. As a result, U.S. has become the largest oil producer, overtaking Saudi Arabia and Russia, with output exceeding 11 million barrels per day in the first quarter of this year. According to the Energy Information Administration (EIA), the U.S. crude oil production would jump 13.5% this year and 26% in the next.

However, production in other oil producing countries is showing signs of waning. The strained relation between the West and Russia, Iraq insurgency, civil unrest and operational issues in Libya, robbery and sabotage in Nigeria oil fields, and international sanctions against Iran over its nuclear program for exporting oil have taken a toll on global oil supplies.

Despite this, IEA maintained its OPEC supply target of 30 million barrels per day for this year and expects non-OPEC supply to increase 1.5 million barrels per day to 56.2 million barrels per day, led by the U.S. (read: A Comprehensive Guide to Oil & Gas ETFs).

Given rising global demand and enough supply, oil prices are expected to remain above $100 per barrel at least for the short term and could even rise further if oil supply disruption persists. This has compelled many investors to look into the oil commodity world. For those investors, we have highlighted a few popular oil ETFs that could be interesting plays to directly deal with in the futures market in the coming months.

United States Brent Oil Fund ((BNO - Free Report) )

This fund provides direct exposure to the spot price of Brent crude oil on a daily basis. It has amassed $53.4 million in its asset base and trades in a small volume of roughly 31,000 shares a day. The ETF charges 75 bps in annual fees and expenses and has lost 1% since the start of the year (see: all the energy ETFs here).

United States Oil Fund ((USO - Free Report) )

This is the most popular and liquid ETF in the oil space with AUM of $595.6 million and average daily volume of about 3.1 million shares. The fund seeks to match the performance of the spot price of light sweet crude oil West Texas Intermediate (WTI). Expense ratio came in at 0.45%. USO has gained over 8% in the year-to-date time frame.

PowerShares DB Oil Fund ((DBO - Free Report) )

This product provides exposure to crude oil through WTI futures contracts and follows the DBIQ Optimum Yield Crude Oil Index Excess Return. The fund sees moderate average daily volume of around 92,000 shares and AUM of $242.6 million. It charges an expense ratio of 79 bps and has added 9% so far this year (read: 3 Country ETFs to Avoid on High Oil Price).

iPath S&P GSCI Crude Oil Index ETN ()

This is an ETN option and delivers returns through an unleveraged investment in the WTI crude oil futures contract. The product follows the S&P GSCI Crude Oil Total Return Index, a subset of the S&P GSCI Commodity Index. The note has amassed $221 million in its asset base and trades in solid volume of more than 308,000 shares a day. It charges 75 bps in fees per year from investors and has returned 8.6% since the start of this year.

Contango: Enemy of Futures Market

While the above products provide the easiest way of gaining direct exposure to the oil commodity, it have serious consequences on the profit (or loss) incurred by the investors. This is especially true as these ETFs and ETNs need to roll from one futures contract to another in order to avoid physical delivery and is thus susceptible to roll yield.

Roll yield is positive when the futures market is in backwardation (the front-month contract is higher than the next-month contract) and negative when the futures market is in contango (the front-month contract is lower than the next-month contract). Investors should note that the state of contango could eat away returns over the longer time periods (read: The Key to Investing in a Futures Backed ETF).

However, the current futures market reveals that crude oil is in prolonged backwardation, which is bullish for the commodity and the oil ETFs. Meanwhile, Brent oil is in mild backwardation as the front-month contract is slightly lower than the next-month contract but this trend will likely reverse after that, indicating prolonged backwardation in the Brent oil market as well.

If the front-month contracts were more expensive than the next month, investors would enjoy profits on every roll, thereby maximizing their total returns. A market in backwardation also signifies that demand exceeds supply boosting oil prices higher. As a result, contango does not look like an obstacle for investors over the next few months.

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