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This article appeared in the April 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Capitalise on a rising oil price with this new exchange traded fund.

Photo of Drew Corbett By Drew Corbett, BetaShares

Crude oil is one of the most important physical commodities in the global economy and is the most commonly traded. Most people follow the price of oil through what they pay at the petrol pump and the reality is, few investors have had access to oil as an investment until now.

Before the launch of Australia's first oil exchange-traded fund (ETF) (ASX Code: OOO) in November 2011, the only way to invest was through complicated instruments such as futures or contracts-for-difference, or indirectly with shares in oil companies. The ETF gives investors exposure to the performance of oil as easily as buying a share.

ETFs are one of the world's fastest-growing investment products. In simple terms, an ETF is a managed fund quoted and traded on a sharemarket such as ASX. ETFs are built like managed funds but trade like shares, meaning that pricing is transparent and they can be bought and sold throughout the trading day.

ETFs generally aim to track the performance of a given index or asset class as closely as possible. They are transparent, liquid, cost-efficient and flexible investment tools, and are designed to be attractive to individuals and institutional investors.

(Editor's note: to learn more about the features, benefits and risks of ETFs, do the free online ASX ETF course.)

How ETFs are structured

There are two types of ETFs: physical replication and synthetic. Physical replication involves holding the asset being tracked to deliver the investment return. This can be seen in products such as the gold ETF on ASX, which is physically backed by gold bullion, or equity ETFs, which hold physical shares.

In some cases, it is impractical and costly to physically store assets, such as oil, and as a result investors around the world use oil futures to gain exposure to the oil market. The oil ETF gains exposure to the oil price by investing its assets into cash and using a swap agreement that aims to closely track the price of an oil futures index.

Although this results in the oil ETF being classified as a synthetic ETF, investors should be aware the product is fully backed by cash, which is ring-fenced and held by a third-party custodian for the benefit of investors. Interestingly, the cash used as collateral will actually generate an interest return similar to the cash rate set by the RBA. Any such interest return will benefit investors in the ETF.

How the oil ETF works

The BetaShares Crude Oil Index ETF aims to track the performance of the S&P GSCI Crude Oil Index, which aims to track the performance of the West Texas Intermediate (WTI) crude oil futures traded on the New York Mercantile Exchange. WTI crude is a light, sweet crude oil that is a global pricing benchmark for more than 160 internationally traded crude oils.

The spot price is often quoted in the financial press but it is not possible to invest in an index based on spot prices because the purchaser cannot take delivery of, and hold, the physical commodity.

Investors should note that tracking the performance of an index based on commodities futures is different from investing in the spot price of the commodity. The spot price refers to a quote for immediate payment and delivery of a particular commodity.

Correlation with oil price shares v ETFs

The BetaShares Crude Oil Index ETF is currency hedged, substantially eliminating the effect of movements in the Australian dollar exchange rate (against the US dollar) to provide a purer oil exposure.

This means investment returns from the ETF will vary from the spot return of oil, but the correlation typically will be very high. For example, as shown in the chart below, the daily correlation between the GSCI Crude Oil Index (the futures-based index tracked by BetaShares Crude Oil Index ETF) and the WTI spot price, has been 0.95 over the past 10 years.

By comparison, the daily correlation between Woodside Petroleum, one of the most popular ASX-listed oil shares, and the spot price of oil, has been only 0.33 over the same period.

An ETF investment compared with shares in a company also minimises company and market risk, such as financial and management risk or earnings surprises, providing a more pure oil exposure.

Daily correlation of S&P/GSCI crude oil index vs. "Spot" oil, Woodside Petroleum vs. "Spot" oil 
1 year hold period - 2001 to 2011

Daily correlation of S&P/GSCI crude oil index vs. "Spot" oil, Woodside Petroleum vs. "Spot" oil - 1 year hold period - 2001 to 2011
Source: Bloomberg. Past performance is not an indicator of future performance

The effect of futures prices on the ETF

Most often, investors in commodities futures do not want to take delivery of the commodity itself, so they usually trade their futures contracts before expiry and replace them with contracts with a later expiry date. This process is known as 'rolling'.

Understanding rolling is important for commodities investors because it affects investment returns. As an example, the new futures contract that investors roll into may refer to a higher future price, which would mean the investor receives fewer new contracts for the same amount invested. Assuming the commodity price does not rise, the rolling will result in a loss.

This phenomenon is known as 'contango'. The opposite can occur, where the new futures contract an investor rolls into may refer to a lower price. Assuming that the commodity price does not drop at expiry, the investor will profit. This is known as 'backwardation'.

The graph below depicts these two scenarios, using the example of a crude oil and a copper futures contract. The crude oil contract that expired in September 2010 was sold and in its place a more expensive contract was purchased - that is, the crude oil futures were in contango, as shown by the bottom line of the graph.

The top line of the graph depicting the copper futures contracts indicates that the September 2010 contract was sold and replaced by a cheaper contract expiring the next month. As the slope of the line indicates, the contracts that expire beyond September 2010 imply a further decrease in the price of copper - that is, the copper futures are in backwardation.

Copper futures and crude oil (WTI) futures: September 2009 curve for August 2010-August 2011 delivery

Copper futures and crude oil (WTI) futures: September 2009 curve for August 2010-August 2011 delivery chart

Source: Bloomberg. Past performance is not an indicator of future performance

Investors should be aware of the composition of returns derived from an ETF tracking a futures index and how they can affect the performance of the ETF. The three components of return in such a product are known as the spot price, the roll return and collateral returns.

The spot price is the return of the commodity price being tracked by the underlying index. The roll return is derived from selling the soon-to-expire futures contracts and reinvesting the proceeds in later-dated futures contracts. Roll return will be positive if the futures curve is in backwardation and negative if the futures curve is in contango. Collateral returns are derived from the interest amounts paid from the cash collateral.

This may seem complicated, but investors should be aware that the historical correlation of the crude oil index versus the spot price has been high. Although past performance is not an indicator of future performance, the oil ETF does provide a simple, direct and unleveraged exposure to oil, available on ASX.

About the author

Drew Corbett is head of investment strategy at BetaShares. He is a pioneer in the global ETF sector and has more than 25 years of financial sector experience in Australia, Asia, Europe and the United States.

BetaShares ETFs are Australian domiciled and trade on ASX.

From ASX

Exchange Traded Funds and Exchange Traded Commodities provides more information about the features, benefits and risks of these products.

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