How to track the oil price using exchange traded funds (ETFs)

Investors wanting to track the soaring oil price with exchange traded funds (ETFs) should take care. Choose the wrong ETF and you could be wasting your time and money.

Regulator is concerned

The Financial Services Authority last month announced it was stepping up its supervision of exchange traded products (such as exchange traded funds or ETFs, and exchange traded commodities or ETCs) over concerns that investors did not always understand these complex financial instruments.

Interest in ETFs as a generally cost-efficient way of tracking individual stock markets and investment sectors has soared in recent years. At the same time the trebling of the oil price since 2009 has made oil ETFs a popular play for investors seeking to cash in on the global boom in commodities.

Oil trackers that don't track

However, as the chart below shows, the range of oil ETFs from the main provider in this area – ETF Securities – has produced widely differing results, even though in theory they all track Brent Oil, one of two main measures of the oil price.

The chart shows that since October 2007, when ETFS launched its exchange traded commodities on the London Stock Exchange, the ETFS Brent 1 month oil ETF has massively underperformed the price of oil. It also shows that none of the ETFs here have kept up with the recent rises in oil prices.  

Why?

On the face of it tracking oil prices shouldn't be difficult because the 'spot price' of oil – the price we hear about every day – is the price of oil futures contracts. Although futures contracts are high risk investments, they can be bought like any other assets such as bonds, shares and gold. So why doesn't owning them enable an investor to track their price effectively?

The ETFS Brent 1mth  in the chart is an oil ETF that owns futures contracts for one month. As the chart shows, it doesn't do a great job keeping up with the price. The other ETFs are the ETFS Brent 1yr , which buys and hold futures contracts for a year, the  ETFS Brent 2yr  which holds futures contracts for two years and the ETFS Brent 3yr  which owns them for three years. 

As the chart shows, the more infrequently these ETFs recycle their futures contracts, the better their over-all performance. However none of them have kept up with oil price increases seen over the last few months.

The illusion

The problem investors need to get their heads around is that there is no continuous oil price. Oil futures, which are the basis of the oil 'spot price', can be bought as much as nine years ahead of a specified delivery date. However, they only represent the 'spot price' for one month in that period.

This all-important month is the last one before the delivery date, which is when the buyer of the futures contract will see his paper contract transformed into 1,000 barrels of oil. This last month is used as a proxy for the price of oil and it is known as the 'front month'. 

The problem for ‘buy-and-hold’ investors is that attempts to capture this ‘front month’ price means buying and owning futures contracts for that one month before they expire. In other words they have to recycle their holdings 100% each month in order to keep up with the price. This ‘rolling’ of futures contracts is expensive and can wipe out any gains investors have made on the oil price.