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Oil a great contrarian trade, but ETF woes cause rethink


In a sea of potential contrarian trades, oil is one that stands out.

The North American West Texas Intermediate (WTI) benchmark has lost more than 75 per cent since the start of 2020, seeing it fall to its lowest price since 2002. The European Brent grade has dropped by almost 65 per cent.

They are the spot prices: there are, of course, futures prices, and it was these, for delivery of WTI in May 2020 that made the almost-unbelievable headlines we saw earlier this month of “negative oil prices.” This was essentially a futures-market anomaly: while the same market drivers that have pushed oil prices lower – a supply glut at the same time that the Covid-19 pandemic has slammed global economic activity – the futures pricing has been further pounded by the trading deadlines.

  • Oil entered an extreme situation of contango, where the futures price of a commodity is higher than the spot price of the contract today; this “super contango” reflected the fact of physical barrels that could not find buyers, and were being sold at distressed prices.

    Oil costs money to store; the dramatic drop in usage because of the economic collapse meant that all the storage facilities were filled up; nobody who could store it wanted to buy it from those who owned the contracts for May delivery, which were due to expire on April 21; so those who owned those contracts had to pay someone to take them off their hands.

    Cue “negative oil prices,” for the first time ever.

    The June WTI futures contract prices are under pressure, too, and a repeat is not out of the question.

    So, who would buy oil?

    Actually, oil is a no-brainer.

    Although the price has been hammered by the glut, crude oil is still absolutely necessary to global economies and markets. That has not changed, and when economies around the world sputter back to life, they will still rely on oil. In its annual World Energy Outlook for 2019, published in November, the International Energy Agency predicted that world oil demand will rise from 96.9 million barrels a day in 2018 to 106.4 million barrels a day in 2040.

    It is true that the Covid-19 pandemic, and the changes to social behaviour that have ensued in the wake of lockdowns, will change demand patterns, and could make the IEA projection miss the mark. We don’t know, and nor do we know whether renewable energy is really capable of making big inroads into oil demand. Oil may not return to 100 million barrels a day – but even if “normal” demand stabilises at 85 million-90 million barrels a day, that presages prices a lot higher than today’s.

    We can be fairly sure that prices around US$15-US$16 for WTI and US$20-US$21 for Brent are well below what it costs most producers to supply into the market; and well below what the big oil-producing nations such as Saudi Arabia, Russia and the US need to balance their budgets (certainly for the House of Saud!) The Covid-19 impact on the oil market has appalled the oil-producing nations, and they are going to have to amend supply accordingly.

    Which leaves the question, how to invest in oil?

    All around the world, oil exchange-traded funds (ETFs), which invest in indices over oil futures contracts, have been pounded by oil futures pricing moves; some leveraged ones, actually into oblivion. Tracking physical commodity prices through oil futures contracts indices has caused major problems for ETF providers: it is not like gold ETFs, where the fund is backed by physical gold – there is no Perth Mint or London Bullion Market Association (LBMA) vaults for oil investors. “Synthetic” commodity exposures that rely on futures contracts have caused trouble.

    Here in Australia, for example, ETF issuer BetaShares’ oil ETF, which has the ASX code of OOO, announced last week that it would stop using one-month oil futures and use the three-month oil futures instead. The issuer faced the real risk of the ETF blowing up, given the way futures pricing was behaving. The change means the fund will no longer directly track its index, until further notice – which means, for the investor, that the fund is not as strongly correlated to the oil spot price.

    On the flipside, BetaShares expects the temporary change to longer-dated futures contracts to reduce the cost of rolling futures.

    Another way of getting oil exposure is through the companies that produce it – of which the Australian share market has no shortage, in the likes of Woodside Petroleum, Santos, Oil Search, Beach Energy and Carnarvon Petroleum. But in oil stocks, investors are exposed to stock-specific risk.

    An alternative stock that gives significant diversified oil exposure could be BetaShares’ Global Energy Companies ETF, which trades under the ASX ticker FUEL. This ETF provides exposure to the 50 largest-capitalisation energy companies globally, excluding Australia. So it doesn’t hold those Australian stocks; but it does have the likes of Chevron, Exxon Mobil, Total, BP, Royal Dutch Shell and Conoco Phillips.

    Since inception in June 2016 the fund has lost 9.1 per cent a year, understandable given that the oil price has been sinking over that time; the index the ETF follows (the Nasdaq Global ex-Australia Energy Index, hedged into A$) has lost 8.1 per cent. So far in 2020, FUEL is down by 39 per cent.

    More importantly, for investors looking forward, the currency-hedged FUEL ETF has shown a correlation of about 0.84 with the Brent crude oil price – which gives it solid credibility as a means of playing an oil recovery.

    The fund is managed for 0.57 per cent a year.

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