The price of crude oil is once again in a downtrend. Last week, CNBC ran a story claiming “US crude extends losses, entering technical bear market, down 20% from 2016 high.” Prior to this, crude oil rallied more than 40% from the beginning of the year to a high of $51.67 per barrel reached in June.

Such price movements offer opportunities for some risk-seeking investors. There are a multitude of Exchange Traded Funds (ETFs) available for retail investors to invest or trade in crude oil. There are straight oil ETFs that are supposed to track the price of crude, there are levered ETFs that magnify oil’s price movements, and there are inverse oil ETFs that allow investors to profit when crude oil prices fall. (See also: The Top 5 Inverse Oil ETFs).

How Useful Are Oil ETFs?

There are some key facts investors need to be aware of before jumping in and buying an oil ETF. The first one being that oil ETFs do a relatively poor job of tracking the price of oil crude oil. How can this be? Oil ETFs are exchange traded funds made up of oil futures contracts. Oil futures contracts expire, however, so the ETF must actively move from the expiring contract to the next contract, a process called “rolling”, to maintain the value of the fund.

On the surface, this doesn’t seem like a big deal, but the problem for ETF investors lies in the fact that two futures contracts are rarely priced the same.  When contracts in the future are priced higher, a situation called contango, the ETF ends up holding fewer contracts than it did before the roll. The table below provides an example.

Future Contract Roll

Month

Value

Price

Contracts

1st

100

$40

2.5

2nd

100

$50

2.0

 

The ETFs value should not be affected by the roll, so the goal of the ETF is to maintain a value of 100 from the first month to the second. Since oil prices are higher in the future, to maintain the ETFs value, the fund requires fewer contracts. Over time this “roll cost” from contango negatively affects the performance of the fund. If oil prices simply stand still, contango ensures that the fund will decline over time, according to ETF.com.

Oil prices are currently in contango, and this is weighing down investment performance.

ETF Performance Year-to-Date

The evidence seems to reflect this fact. The price performance of various oil ETFs in 2016 shows investors may not be getting what they expect, regardless of which bet they took on the direction of the oil price. For example, three Oil ETFs (USO, USL and DBO) are all lagging the price of oil (blue line) in 2016.

Source: Tradingview

Inverted ETFs are not much better, as seen in the chart below. Oil prices are up from where they started in 2016, so one would expect ETFs designed to bet on a falling oil price to be underperforming. The ProShares Short Oil & Gas ETF (DDG) under-performed in February when oil prices fell sharply. An investor who sold oil at the beginning of the year would have made a return of 40% by February as shown by the inverted price of oil (blue line). The same investor would have made only 8% by owning the DDG ETF.

The DB Crude Oil Short ETN (SZO) did a better job of tracking oil’s fall in the early months of 2016, but has been much less volatile in the rising price environment seen recently. This is perhaps a good thing for investors right now, but this ETF may eventually lag the price of oil in a falling price environment and could fail to deliver expected returns because of its low correlation with the underlying oil price.

Source: Tradingview

The Bottom Line

Investors need to be careful about return expectations when investing in oil related ETFs. The roll that is a fact of life in the futures market can severely affect the return performance of these funds. The performance related issues also seem independent of the directional bet on the price of oil. For example, inverted ETFs also show a relatively low correlation with the underlying price movement of crude oil.

Disclaimer: Gary Ashton is an oil and gas financial consultant who writes for Investopedia. The observations he makes are his own and are not intended as investment advice. Gary does not invest in any of the ETFs mentioned.

 

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.