Direct investment in crude oil products used to be limited to major financial institutions and oil companies themselves, but the development of the ETF industry in the U.S. has democratized the investment process in many ways, including making investments in various oil products accessible to average investors. There are a number of exchange-traded products that offer exposure to prices of various types of oil utilizing an array of investment strategies. Whether you’re looking to bet on short-term movements in oil prices or hedge against skyrocketing prices, ETFs offer an efficient, cheap, and easy way to gain exposure to commodity prices [see also USA Oil Reserves: The World’s Largest?].
The Five Key Questions
When considering a potential investment in oil ETFs, there are several factors to consider and understand. These include:
ETF vs. ETN: When it comes to investing in oil, the choice of structure matters in a very significant way. The choice between ETF and ETN can impact your tax consequences, administrative burden, and returns. Some investors are hesitant to use ETNs, but it might make sense in this case.
Duration Matters: While many of the products look the same on the surface, the nature of the underlying futures contracts can have a major impact on bottom line returns. ETFs that hold front month contracts are very different from those that spread exposure over multiple periods.
Brent vs. WTI: While most investors are familiar with West Texas Intermediate, Brent Crude is perhaps becoming the more relevant oil contract. Accessible through BNO, Brent Crude might be a better way to play oil prices for some investors.
How Oil ETFs Work
At a high level, oil ETFs function just like any other exchange-traded product: they track an underlying index. But unlike traditional equity ETFs that hold a basket of securities comprising the underlying indexes, most oil ETFs achieve exposure in a very different manner. Because physically buying and holding most oil and gas products is prohibitively expensive, oil ETFs instead generally invest in near-term futures contracts on the underlying commodity to gain exposure to prices. While this strategy may track spot prices fairly closely in certain environments, it may be way off in others [see also Brent Crude vs. WTI: The Best Performing Commodity].
If oil prices are in contango (longer term oil contracts are priced higher than near term ones), funds implementing this strategy will be continually rolling forward into more expensive contracts (see a more thorough discussion of this concept here). Other oil ETFs are structures as exchange-traded notes (ETNs), meaning that they actually own either the physical commodities or futures contracts, but are rather senior unsecured debt instruments issued by a financial institution that agrees to pay investors the return on a linked underlying index. The ETN structure reduces tracking error, but introduces investors to counterparty risk.
ETFdb Pro members can view the Energy Bull ETFdb Portfolio, which outlines a strategy for investors who believe energy prices are entering a long term bull market. [For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro]
|USO||United States Oil Fund||04/10/2006||0.45%|
|BNO||United States Brent Oil Fund||06/02/2010||0.75%|
|DBO||DB Oil Fund||01/05/2007||0.50%|
|OIL||S&P GSCI Crude Oil Tot Ret Idx ETN||08/15/2006||0.75%|
|USL||United States 12 Month Oil||12/06/2007||0.60%|
|OLEM||Pure Beta Crude Oil ETN||04/20/2011||0.75%|
|OLO||DB Crude Oil Long ETN||06/16/2008||0.75%|
|OILZ||E-TRACS Oil Futures Contango ETN||06/16/2011||0.85%|
|CRUD||WTI Crude Oil Fund||02/23/2011||1.54%|
|TWTI||Oil Trendpilot ETN||09/15/2011||1.10%|
- USO: By far the most popular oil ETF, this fund offers exposure to front month WTI futures.
- BNO: This product has a similar strategy to USO, but instead offers exposure to Brent crude futures.
- DBO: DBO offers exposure to multiple WTI futures contracts in order to provide its exposure.
- OIL: This ETN invests in both WTI futures as well as short term Treasuries to offer one of the more unique methodologies in the space.
- USL: This ETF invests in 12 different WTI contracts at the same time in order to provide a longer term view on the commodity.
- OLEM: This ETN typically holds one WTI contract until it reaches its automated roll, when it can invest in any contract available; this may help mitigate contango issues.
- OLO: Similar to OIL, this fund invests in 3 month T-bills as well as WTI futures.
- OILZ: This product is specifically designed to combat contango by taking short positions in near term contracts and long positions in those that expire further out.
- CRUD: CRUD measures WTI by holding multiple futures contracts at the same time.
- TWTI: This product will either invest in WTI contracts or U.S. 3 month T-bills depending on a simple historical moving average.
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Impact Of Contango On Oil ETFs & ETNs
It is extremely important for investors considering a position in oil ETFs to understand that they will not be getting exposure to spot oil prices, but rather to futures prices–which can vary dramatically from spot prices. Specifically, the slope of the futures curve can have a major impact on bottom line returns, as illustrated by the chart below comparing spot West Texas Intermediate prices with the price of the United States Oil Fund (USO). Though oil prices climbed over the six year period shown, the price of USO declined by almost 50% due to the consistent contango in oil futures markets [see How To Understand Contango].
Tax Consequences: ETF vs. ETN
Another key consideration when evaluating oil exchange-traded products relates to taxes. Though the products highlighted above are generally similar, there are some structural nuances that are worth investigating. Specifically, commodity pools such as USO are technically structured as partnerships. These funds will deliver a K-1 to investors on an annual basis, and will be taxable annually (at a blended rate of about 23%) regardless of whether or not a position is liquidated [see When ETNs Are Better Than ETFs].
ETNs, on the other hand, offer more traditional tax treatment; gains and losses are reported on a Form 1099 only when liquidated, and the taxes incurred will depend on the holding period (i.e., long term gains will be taxes at 15%).
[The ETF screener allows investors to filter by tax form related to each ETF; if you'd like to avoid K-1s, this can be a useful tool]
Inverse and Leveraged Options
As is the case with most commodities, there are a variety of options for investors looking to gain leveraged or inverse exposure to oil prices through ETFs. Note that these funds can often be quite dangerous, so close monitoring and stop-loss orders are a must [see also 25 Ways To Invest In Crude Oil].
|DNO||United States Short Oil Fund||Yes||-100%|
|SZO||DB Crude Oil Short ETN||Yes||-200%|
|UCO||Ultra DJ-UBS Crude Oil||No||200%|
|SCO||UltraShort DJ-UBS Crude Oil||Yes||-200%|
|DTO||DB Crude Oil Dble Short ETN||Yes||-200%|
|DWTI||3x Inverse Crude ETN||Yes||-300%|
|UWTI||3x Long Crude ETN||No||300%|
|FOL||2x Oil Bull/S&P 500 Bear||No||200%|
Indirect ETF Investment Options
There are some drawbacks to investing “directly” in oil through the ETFs mentioned above. Since these ETFs primarily use futures contracts, they don’t always track spot prices closely (in certain environments, there may be significant discrepancies between the return on a basket of futures contracts and the spot price for the underlying asset). Moreover, in certain environments, commodity prices can exhibit extreme volatility making them inappropriate for some investors [see also UNG vs. USO: Decoupling Or Correction?].
For those looking to benefit from increases in oil prices without investing in commodities, there are a variety of energy ETFs that hold stocks of companies engaged in the production and distribution of oil. Broad-based energy funds generally have significant allocations to oil companies (such as Exxon Mobil, Chevron, and ConocoPhillips), as well as providers of drilling and other services to the energy industry (such as Schlumberger).
|XLE||Energy Select Sector SPDR||0.18%|
|XOP||SPDR S&P Oil & Gas Explor & Product||0.35%|
|IEO||Dow Jones U.S. Oil & Gas Exploration & Production Index Fund||0.48%|
|PXE||Dynamic Energy E&P||0.60%|
|WCAT||TR/J CRB Wildcatters Exploration & Production Equity ETF||0.65%|
|UNG||United States Natural Gas Fund LP||0.60%|
|UHN||United States Heating Oil Fund LP||0.60%|
Master Limited Partnerships (MLPs)
MLPs have become quite trendy in recent years as many investors have hopped aboard these assets to gain access to their sky-high yields. Oil-based MLPs are typically involved in the infrastructure of this commodity including pipelines and other means of transporting the fossil fuel. While they are an indirect play, their dividends may be too enticing to pass up.
|AMJ||Alerian MLP Index ETN||4.86%|
|AMLP||Alerian MLP ETF||4.48%|
|MLPI||E-TRACS Alerian MLP Infrastructure Index||4.81%|
|MLPN||Cushing 30 MLP Index ETN||5.20%|
|YMLP||Yorkville High Income MLP ETF||n/a|
|MLPW||E-TRACS Wells Fargo MLP Index||4.91%|
|MLPY||Cushing MLP High Income Index ETN||6.73%|
|MLPG||E-TRACS Alerian Natural Gas MLP Index ETN||5.34%|
As oil ETFs have grown in size, some regulatory authorities have become concerned that the size of these funds is facilitating speculative behavior and contributing to overall market volatility. Most of the investigation and review on this subject has focused on natural gas futures contracts owned by UNG, but it is likely that any regulations would have an impact on all exchange-traded commodity products that utilize futures contracts to track prices. While the ultimate outcome remains to be seen, the most likely scenario is the implementation of position limits that prohibit a single fund from owning more than a predetermined number of contracts. Depending on the threshold determined, this could prevent commodity funds from expanding further, and may even force some to reduce their positions [see also Major Countries Burn Up Crude Reserves: Big Oil In Trouble?].
Oil ETF Price Movers
In the short term, predicting the factors likely to move the prices of oil ETFs is a daunting task. Given the presence of speculators in oil markets, as well as the impact of market news, short term prices can sometimes experience significant volatility. Over the long term, however, factors that impact oil prices are more clear, and include:
- OPEC Production Levels: The underlying investments of the ETFs in this ETFdb Category will be exposed to the decisions of this cartel on oil prices and production levels. If concerns over weak demand arise, OPEC may decide to cut production. If however oil-producing nations are looking to increase revenues, increases in supply could lead to lower prices.
- Alternative Energy Production: Demand for crude oil and natural gas will depend significantly on the development of alternative energy industries in coming decades. If solar energy and wind energy become viable sources of clean, renewable energy, demand for crude oil could diminish. If however, these industries continue to encounter obstacles on the road to sustainability, prices may continue to be propped up by dependence on oil.
- Geopolitical Tensions: With much of the world’s proven oil reserves located in the Persian Gulf, the level of world output depends in large part on the stability of an occasionally unstable region. In the event of disruptions in crude oil production, the operations of companies in the energy sector may be impaired.
- Natural Disasters: Generally unpredictable in nature, natural disasters, particularly hurricanes, can have a major impact on prices of oil and gas. Devastating storms usually result in significant output declines, months of recovery time, and extended reliance on alternative sources of energy.
- New Discoveries: In recent years, we have seen major discoveries of crude oil off the coast of Brazil and huge natural gas reserves near Louisiana. To the extent that major discoveries are made going forward, prices may decline in response to increased global supplies.
ETFdb Analysts Recommend
For investors looking to make a short-term play on oil prices, the United Stated Oil Fund (USO) or United States Brent Oil Fund (BNO) are your best bets; these products hold short term futures contracts, meaning a greater sensitivity to spot price changes.
For those looking to place a long term bet on crude oil prices, we like CRUD (which is constructed to mitigate the impact of contango) and also OLEM, which has certain tax advantages as an ETN.
Further Reading on Oil ETFs
If you’re interested in oil ETFs, here’s some more advanced reading: