Oil prices are back in focus. A combination of falling production in Venezuela, US President Donald Trump cancelling the Iran—US deal and ongoing global growth have all played their part in pushing oil prices higher.
With production tight and the Organisation of the Petroleum Exporting Countries (OPEC) unlikely to voluntarily increase supply it is possible that oil prices could make further gains from here. For an investor, what is the best approach to profit from the oil price?
Investing in oil — the spot price versus the futures market
In a previous note, we outlined in some detail the difficulties that investors can face when trying to own commodities, due to exchange traded funds (ETFs) owning futures rather than the physical product. Oil falls into this space — whenever you buy an oil ETF such as ETFS WTI Crude Oil (CRUD LN) you are getting exposure to a future. It is simply too difficult to store crude oil without incurring significant storage costs.
If the shape of the futures curve is upwards sloping, each time the near—term contract is rolled into one that matures at a later date, there is a loss of value known as a ‘negative roll yield’. When oil prices sell off heavily this can cause a significant drag on returns for investors that want to profit from a rebound in prices.
Investors in early 2016 found this out the hard way — the oil ETF rallied by 9% while the oil spot price was up more than 40%.
Chart 1: Oil ETF investing in futures versus the oil spot price