Why You Can’t Buy Spot Oil - Yahoo Finance

Oil has been in the headlines for all the wrong reasons lately. Futures prices for a barrel of crude oil dipped below zero earlier this month, a shocking phenomenon that’s never happened before.

The wild activity in the oil market has caught the attention of many investors who are interested in capitalizing on the woes of the commodity. They are interested in buying oil at current ultra-low prices and selling it in a few weeks, months, or years from now for a tidy profit.

What they want is exposure to the spot price of oil, but what they can actually get through investment products—including exchange-traded funds—is significantly different than that.

What Is Spot Oil?

According to the Energy Information Administration, the spot oil market is “a market in which oil is bought and sold for immediate or very near-term delivery,” while the spot price of oil is “the price for a one-time open market transaction for immediate delivery of a specific quantity of oil at a specific location where the commodity is purchased at current market rates.”

In other words, the spot price is what you would pay to take physical delivery of oil today—on the spot.

Can’t Buy Spot

Participants in the spot market tend to be energy companies that deal with physical barrels of oil on a day-in and day-out basis, including producers and consumers of crude, like frackers and refiners.

There are dozens of spot oil markets around the world, including the market for West Texas Intermediate crude oil (WTI), a popular benchmark for U.S. crude.

If you’re like the average person, you probably have no interest or ability to take delivery of physical oil that is usually traded in lots of thousands or millions of barrels.

At the same time, there is no ETF on the market that holds barrels of oil in a storage facility, like there is for gold, such as the SPDR Gold Trust (GLD). The cost of maintaining such an arrangement would be steep; dollar for dollar, it’s much more expensive to store oil than it is gold.

Futures Alternative

So, how does an investor buy spot oil? Outside of renting or buying storage space for physical barrels of crude, they can’t. It’s not something that is practical for the average individual or even institutional investor.

That said, there are ways of getting some type of exposure to spot oil prices. Oil futures are the most straightforward way to do that. Oil futures contracts are an obligation to buy or sell the commodity on some future date. There are numerous oil futures contracts corresponding to every month of the year for the next decade.

Prices for these contracts are usually tied closely to the spot price of oil. As futures contracts near expiration, they tend to converge with the spot price of oil as they essentially become contracts for the near-term delivery of physical crude oil barrels.

That usually keeps oil futures prices in line with spot oil prices.

Pitfalls Of Futures

ETFs like the United States Oil Fund LP (USO), the United States 12 Month Oil Fund LP (USL) and the Invesco DB Oil Fund (DBO) employ a strategy of holding oil futures to provide oil price exposure to investors.

But while oil futures prices tend to track spot oil prices on a day-to-day basis, a strategy of continuously holding oil futures contracts results in significant deviation from spot price performance over longer time periods.

This is because oil futures contracts expire each month, forcing any ETF that holds front-month futures to roll their positions into later-dated contracts. When those later-dated contracts are cheaper in price, it’s known as backwardation; when they are more expensive, it’s known as contango. (Read: A Guide To Contango & Backwardation)

Contango, which reflects the cost of storing crude oil over time, has been the predominant state of the oil futures curve since USO’s inception in 2006 (though there have been periods of backwardation). In those 14 years, the second-month crude oil contract has been, on average, 1% more expensive than the front-month contract.

This leads to a roll cost each month as funds like USO sell cheaper-priced contracts for more expensive contracts. Over time, that cost can be quite substantial; for example, since its launch, USO is down nearly 97%, compared to a loss of 76% for spot oil prices.

Roll costs are an important consideration for investors in oil exchange-traded products, and make it difficult to replicate the performance of spot oil prices.

Oil Futures (Yellow) Vs USO (Blue)

Minimizing Roll Costs

To get around the issue of roll costs, some funds—like the aforementioned USL and DBO—purchase oil futures contracts outside of the front-month contract, reducing the need to roll their positions.

USL holds a basket of 12 different futures contracts, so it only has to roll one-twelfth of its holdings each month, reducing roll costs. DBO holds futures contracts that minimize its contango exposure; currently, it owns February 2021 futures, meaning it won’t have to roll its position for up to nine more months.

Even USO—which, for most of its existence, held exclusively front-month oil futures—has become a multicontract fund after position limits and steep roll costs forced the fund to diversify its futures contract exposure. Currently, the fund holds a hodgepodge of different contracts on the futures curve.

Consider Equity ETFs

Admittedly, oil futures ETFs are a very imperfect way to get exposure to oil prices. They have their uses as tools for short-term trading and hedging, but they are not designed for holding periods of months, let alone years.

For that, investors may want to look toward energy equity ETFs. The stocks that these funds hold are leveraged to oil prices, and with them, investors don’t have to worry about the steady decay of roll costs. (Read: Oil ETFs For The Coming Rebound)

Contact Sumit Roy at sroy@etf.com

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Why You Can’t Buy Spot Oil - Yahoo Finance

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