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What is the best way to make money out of oil?

8 February 2016 | By Darius McDermott

With the price of oil having fallen as low as US$28 a barrel last month, the question on many investors lips is should I buy oil?. If so, how?

The answer to the second part of that question really boils down to two key choices: do you invest in the commodity itself or do you buy energy equities?

The spot price versus the futures

Going right back to basics, oil, like most commodities, trades with both a spot price (which is what it would cost to buy a barrel of oil today) and a future price. The trouble is, where do you store a barrel (or several hundred) of oil?

So most buyers purchase a futures contract for delivery of oil at a later date, be it next month or next year. When the forecast prices are rising, futures are described as being in 'contango' – meaning you are paying more than the current spot price per barrel. When the forecast prices are declining, futures are described as being in 'backwardation' – you are paying less than the spot price per barrel.

As a contract nears expiry, market arbitrage ensures futures prices converge with the spot. Assuming the contract holder doesn't actually want to take delivery of their barrels, they must either sell out of the contract or roll it into a new futures position.

How do you buy oil directly?

So if you're advising individual investors that want to get direct exposure to something like Brent or West Texas Intermediate, they're most likely looking at an exchange traded product or fund (ETP or ETF).

An ETF might either buy and hold futures contracts within the fund itself as described above, or it might track a commodity index that is priced using futures prices. Either way, contango and backwardation will be relevant to profitability.

Globally, there are more than 2,000 crude oil ETF securities according to Bloomberg data, including various leveraged, hedged, long and short products – all of which will have risk/return characteristics that need to be analysed on a case-by-case basis.

The question broadly, though, is whether the direct buy is a good approach. The simple answer is, in my opinion, not right now. The detailed answer requires a bit more explanation.

Oil in contango

Theoretically, you ought to be able to simply buy oil when prices are on the way up and make money out of it. But think about it in the context of the example below.

Say you invest today and the spot price of crude is US$30, for simplicity's sake. Now imagine in one month's time the spot has risen to $40 (again, just for the sake of the example). You've made an easy $10 a barrel right?

Well, not quite. Remember investors buy a product that is priced using futures.

So you will have effectively bought futures contracts for one month that are priced at, say, $35 a barrel. If the spot price shot up to $50 or $60 then sure, you'd come out well ahead.

However, if the spot only reached $35 by the end of the month, you still wouldn't profit because you already paid $35 for the futures. If the crude price doesn't increase at all but stays flat at $30 or even falls, you would lose money.

For this reason, the performance of a commodity ETP will rarely match the performance of the spot price and it's rare for a commodity ETP to make a decent return when futures are in contango.

As of the date of writing, the market is quite steeply in contango.

Read more: Finance and investment wrap - February 2016

Oil in backwardation

On the other hand, if the forecast price of oil is declining—i.e. the futures are in backwardation—ETP returns have a better chance of outperforming the spot price, at least in the short term.

This is because each time a futures contract expires, the price of the next futures contract it is rolled into is cheaper and the difference can be recouped as profit. This is known as the roll yield. Roll yield will make a positive contribution when futures are sloping downwards and a negative one futures are sloping upwards.

Of course, you have to remember in this situation you're still investing in a commodity that is declining in value and inevitably either the commodity becomes completely worthless, in which case all the roll yield in the world won't help you, or supply finally begins to outstrip demand again and the futures curve moves back into contango.

Counterparty and provider risk

Now you may be thinking one month examples are all well and good, but why not consider longer periods of time where larger price rises are more likely?

It is definitely possible to find ETPs buying one and two-year futures contracts, but there are a couple of other risks to understand when buying commodity products, which can be exacerbated by a longer time frame.

One of these is counterparty risk. The counterparty is usually a large financial institution, which should provide some reassurance, but we all remember what happened in 2008 with Lehman Brothers, who held many futures contracts on their books.

Furthermore, when it comes to longer contracts, ETP managers have got to be confident the oil providers themselves will be liquid in one or two years' time. In today's environment, that's no certainty.

Perhaps the most salient point for individual investors is that when they assess an oil ETP, a lot of these factors impacting potential profits are not necessarily transparent.

Individuals cannot easily see the prices of specific futures contracts held by the fund, nor with whom they are held. Nor is it easy to see crude oil futures prices, generally, without paying large sums to access professional data.

So how do you get into oil indirectly?

As mentioned initially, another way of investing in oil is to buy energy equities. Always keep in mind that the correlation between commodity values and companies' share prices can be loose, but if you're seeking this kind of exposure have a number of ways of going about it.

Let's take a quick look at the options. Investors can:

  • Research and buy stocks in individual companies themselves
  • Buy a passive energy equity index fund or ETF
  • Buy a specialist global energy sector equity fund.

Browse all Elite Rated funds

Share prices are moved by more than just oil

While the price paid for a barrel of oil will obviously affect an energy company's revenue, stock specific factors including exploration and production costs, fiscal management, gearing and operational risks can also impact share prices.

Besides this, many of the sector's biggest players—Shell, BP, ExxonMobil, Petrobas to name a few—operate on each side of the coin, so to speak. Their exploration and crude oil production are known as 'upstream businesses', while a range of refinery, petrochemical and retail fuel operations are referred to as 'downstream businesses'.

So when the price of crude oil rises, upstream business revenue may increase, but overall profits may be offset by costs rises and reduced margins for downstream businesses.

The point is, even if you could predict oil price movements reasonably accurately, there's no guarantee the energy company in which you invested would follow suit.

Moreover, investors that aren't particularly knowledgeable in energy often gravitate to the sector's blue chips in an effort to reduce risk, even though these companies may not offer the best opportunities for returns.

The same problem exists with passive, market capitalisation-weighted indexes, which will naturally be 'over-invested' at the top end of the market.

Actively-managed funds

Actively-managed specialist energy funds, on the other hand, tend to invest heavily in small and medium-sized companies, as well as large ones. Many managers in this space advocate these stocks are better placed to capture the most attractive themes and exposures of the sector, particularly in up markets.

Over the past year or so, this approach has led most active energy funds to underperform the MSCI World Energy index, which has benefited from the relative stability of a significant weighting in blue chip stocks. As explained, these large companies are less leveraged to the oil price and therefore better able to withstand falls in the value of the commodity.

On the flip side, if you anticipate the oil price is going to begin climbing again soon(ish), this lower leverage will start to work against the sector stalwarts. The small to mid-cap holdings that cause the specialist funds to be more volatile than the index also have the potential to generate greater returns on the upside.

For my part, I believe a specialist energy fund such as Guinness Global Energy, which is part of the Chelsea Financial Services Selection, is one of the better ways to gain exposure to oil right now and ultimately more promising than either a direct ETP or an equity ETF.

Learn more: How to choose a managed fund

A final caution is that not all analysts do believe oil is yet due a rebound. Most of us have probably seen a news article or two in recent weeks speculating oil could go as low as US$10 a barrel.

Timing these kinds of market movements is not the domain of the average individual investor (nor always the professional one, to be frank) and anyone investing should be very clear that the risks of losing money are undoubtedly high.

So in answer to the first question—should I buy—if you believe oil has hit rock bottom, by all means there are ways to take a punt, but don't let speculative enthusiasm overtake due diligence and a prudent analytical approach.

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Darius McDermott, Managing Director - February 2016

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