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How to Play Oil as a Commodity With ETFs

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The hottest commodity oil has been on a solid run this year thanks to a tightening oil market and rising global demand. Rounds of news about new supply disruption are adding strength to the oil price, making the case for oil ETFs appealing.

Supply Declining

The looming Iran sanctions and falling Libya and Venezuela output were the biggest catalysts in driving oil price lately. The United States is expected to halt oil exports from the fifth-biggest producer Iran by November though some waivers can be granted while production in Libya has halved in five months to 527,000 barrels per day. Venezuela’s worsening economic crisis has forced the country to curtail its output to below 2 million barrels per day, which has been halved since 2005.

Now, the strike by hundreds of workers on Norwegian offshore oil and gas rigs has led to the shutdown of one shell-operated oilfield, escalating supply worries. A Canadian production outage at the 360,000-bpd Syncrude oil sands facility has reduced flows into Cushing, OK and is expected to continue doing so till September. Further, ongoing geopolitical tension in the Middle East is supporting the higher oil price.

The Organization of the Petroleum Exporting Countries (OPEC) and other top crude producers, agreed to raise output by about 1 million barrels per day from July in order to offset global production losses in countries including Libya and Venezuela. However, the move will not be able to make up for higher demand thus pushing the price higher (read: What Does the OPEC Agreement Mean for Energy ETFs?).

Demand Rising

Global demand for oil has been picking up buoyed by improving economic growth since the financial crisis and continued to be strong during the peak summer season.

However, China’s demand may be at risk due to Trump’s tariff threats. President Donald Trump has threatened to levy new trade tariffs of 10% on $200 billion worth of Chinese goods, a move that will intensify further trade tensions between the world’s two biggest economies (read: Beyond China, These Asia ETFs to Feel the Heat of Trade War).

How to Play?

Given the improving supply/demand trends, crude prices are expected to remain above $70 per barrel at least for the short term and could rise further if oil supply disruption persists. This has compelled many investors to look into the oil commodity world. For them, 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 through future contracts. It has amassed $104 million in its asset base and trades in a good volume of roughly 190,000 shares a day. The ETF charges 90 bps in annual fees and expenses. BNO surged 22.2% so far this year (read: Top ETF Events of 1H to Watch in 2H).

United States Oil Fund (USO - Free Report)

This is the most popular and liquid ETF in the oil space with an AUM of $1.8 billion and average daily volume of nearly 20.6 million shares. The fund seeks to match the performance of the spot price of West Texas Intermediate (WTI or U.S. crude). The ETF has 0.76% in expense ratio and has gained 25.5% so far this year.

Invesco 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 solid average daily volume of 1.4 million shares and has AUM of $376.4 million. It has an expense ratio of 78 bps and has gained 23.3% in the same time frame.

United States 12 Month Oil Fund (USL - Free Report)

USL provides investors exposure to front-month WTI futures contracts. It is unpopular and less liquid with AUM of $83.3 million and average daily volume of 30,000 shares. Expense ratio comes in at 0.86%. The fund is up 21.4% so far this year (read: How to Play Oil's Surge with ETFs).

ETRACS S&P GSCI Crude Oil Total Return Index ETN

This is an ETN option for oil investors and its performance is linked to S&P GSCI Crude Oil Total Return Index, which reflects the returns through an unleveraged investment in the WTI crude oil futures contract. The note has amassed $17.2 million in its asset base and trades in a meager volume of about 600 shares a day. Its expense ratio comes in at 0.50% and the note has returned 31.3% in the year-to-date timeframe.

State of Backwardation: A Big Bull for Oil

While the above products provide the easiest way of gaining direct exposure to the oil commodity, these have serious consequences on the profits (or loss) of 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 are 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.

The oil futures market is currently in a state of backwardation, signaling that the oil market is tightening and demand is robust paving the way for an oil rally. This trend is likely to persist at least in the near term, acting as the biggest catalyst for the commodity.

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