Crude Oil ETFs

Crude oil prices are always in the forefront of investors' minds because it affects our daily lives on a personal level and economic prospects on a grander scale. Last year, NYMEX crude oil prices, which is based on the West Texas Intermediate (WTI) crude oil, hit a record $147/barrel. Since that high, prices have dramatically dropped down to a low of around $32/barrel and is now back to around the $44/barrel level.

NYMEX crude oil prices follow futures contracts. There is a contract for each month, with a price associated with it, determined by market forces, supply, demand, and geopolitical issues. Near the end of each month, the corresponding contract expires and the holder of the futures contract must take delivery of the underlying oil. For this reason, many investors must sell an expiring contract and trade the contracts of future months, unless they want to take delivery of the oil.

For the average retail investor, investing in futures contracts is simply not practical because they lack the sophistication or resources to do so. Instead, they turn to investing in the oil companies themselves, mutual funds, or if they want more direct exposure to the price of oil, there are exchange traded funds (ETFs) that invest in futures contracts. In fact, when we hear quotations of "the price of oil", it is the price of WTI crude oil as tracked by the New York Mercantile Exchange (NYMEX). The price of the current month's contract is typically tracked until the 20th of each month, at which time, the next month's contract price is used - for a schedule of NYMEX contract roll overs go here: http://www.nymex.com/CL_term.aspx

In Canada, a company called Horizons BetaPro ETFs offer a couple of ETFs that allow investors to bet on both the rising or falling of oil prices. HOU is the symbol of the ETF on the Toronto Stock Exchange (TSX) that bets oil prices will go up (bullish) and HOD is the symbol of the ETF that bets oil prices will do down (bearish).

In the New York stock exchange, a corresponding ETF that bets on oil is USO, which got so big (20% of any months' NYMEX crude oil contracts), that there are concerns it is affecting the price of oil.

An ETF such as HOU or USO works by holding NYMEX crude oil futures contracts without any intention of taking delivery of the underlying oil that the contracts are written against. Because of this, each month, the ETFs must roll from the current month's contracts to the next month's. This means selling the current month's contracts at a predetermined time each month, over a predetermined number of days and proportions.

For HOU, the roll occurs from the 7th to the 9th business day of each month, so that on the 7th business day, 25% of the contracts rolled over to the next month, on the 8th business day, 50% are rolled over and by the end of the 9th business day, 100% of the contracts are from the next month.

For USO, the roll dates are published on a website and the process of rolling over to the next month's contracts is done over a four-day period.

The process of rolling over contracts from one month to the next presents an issue for holders of the bullish ETFs, due to a concept called "contango". Contango describes the situation where by the current month's contract price is lower than the next month's contract price. For the past number of months, the difference can be as high as eight dollars. Contango is a problem for bullish ETFs because during roll over, the ETF must sell at the lower contract price and then buy back the next month's contract at a higher price. However, in a market where by oil prices are declining, the next month's contract price decreases back to the level of the current month's price. The effect is that while the price oil appears to have not moved, the bullish ETF can decrease in value significantly.

For example, if we take HOU, which achieves a daily performance of 200% of the increase or decrease in the price of whatever month's contract it is tracking. Let's say at roll over, HOU trades at a price of $6 and April's is $40 while May's contract price is $45. If after roll over, the May price goes back down to $40 for a decrease of $5 or 8.9%, the price of HOU will decrease by double this rate or %17.8, to $4.93. So, even if oil prices appears to have remained the same, HOU will have decreased due to contango.

Of course, there are many other factors that could change this. As of this writing, Iran is inching towards nuclear capacity and Israel is vowing to put a stop to it. Should an incident break out in this region of the world, the flow of oil would be affect and the price would shoot up. North Korea is comtemplating testing missiles, potentially causing instability in Asia, which could again affect the flow of oil, causing prices to increase. If China recovers faster than expected, the increased demand could put upward pressure on oil prices. Further production cuts from OPEC could reduce the supply available, again putting upward pressure on oil prices.

Meanwhile, many of the world's economies are in significant decline, taking with it demand for oil and therefore continuing to put downward pressure on oil prices. The inventory levels for WTI crude in the storage capacities at Cushing, Oklahoma in an important indication of the supply situation. Inventory has been increasing for weeks and weeks now, but the inventory reading a couple of weeks ago showed a decrease, and last week it showed a smaller than expected increase. Should inventories continue to increase significantly, there will be downward pressure on oil prices but if there is any indication that inventory is decreasing (perhaps due to the summer driving season or hurricanes or lowered production from OPEC or non-OPEC producers), there will be upward pressure instead.

On a daily basis there are cues on where the price of oil may be headed and it is important to stay abreast of new developments.