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For Commodity Exchange-Traded Products, the "Futures" are Uncertain


commodity-exchange-traded-products-future-is-near-bodyFollowing this week’s stunning collapse of WTI crude oil exchange-traded funds, and exchange-traded notes, both referred to as Exchange-Traded Products (ETPs), retail investors were tagged with huge losses. The event was probably best summed up by cocky, professional oil traders as a fight between “muppets and sharks.” We believe that these traders may want to keep their mouths shut as a lot of “funny business” may have been behind the May WTI futures contract crashing through zero on April 20 and the WTI June futures contract plunging 68% intra-day on April 21. However, that may be for a future blog post.

We think that a broader discussion needs to be had around the general public buying and holding commodity-based ETPs whose holdings consist of futures contracts (usually the nearest month contracts) and cash to meet margin requirements from their Futures Commission Merchant (FCM).

The natural state of commodity futures curves is what is referred to as “contango,” a fancy way of saying that the future value of the commodity is higher than the current or “spot.” The reason for this contango is because commodities such as crude oil do not pay interest or dividends and demand a cost for storage and finance. The size of those costs determines how much higher a commodity is worth in a month versus today (or how a July future has a higher price than a May contract). An important caveat is that commodity futures curves are not always in contango. When things like short squeezes occur, or supply shocks hit, immediate demand spikes up, and the futures curve goes into a state known as “backwardation.” In this case, the spot price is higher than the future price. 

We may want to pause here for a moment and reflect upon whether a retail investor should be involved in a product where he or she has to know what contango and backwardation mean. We say that because if an investor wants to own ETPs that replicate a basket of futures—usually the closest and next closest to spot—they have to understand these concepts.

Most commodity-based ETPs invest in the front-month (in our present case, June) futures contract and as a month progresses, roll to the next contract (July). Therefore, when you buy and hold commodity-based ETP, where for the majority of the holding period has the futures in contango, there is a significant drag on performance caused by the front contracts rolling down toward the lower spot price and the cost to roll out of the near-contract as it approaches settlement to a contracts further out. If the curve is contango, these rolls cost money and reduce the performance of the ETP.

Let us take look at a fictional example of what a commodity futures curve in what we will call “normal” contango. Let us also assume an ETF that must track the front month (in this case June):

Estimated Spot Price

$19.00

June 2020

$20.00

July 2020

$21.00

August 2020

$22.00

As you can see, the difference between the estimated spot price and June is $1.00, or 5.26%, higher and July contract is $1.00, or 5%, higher. Therefore, if this relationship remains constant, the ETP sees the June contract rolling down toward $19, and rolling out of that June contract to July at a loss. Long story short, if a retail investor wants exposure to WTI Crude, buying and holding an ETP can lead to a significant loss of value, especially in non-volatile periods. An extreme example would actually be ETP products that track the VIX (not a physical commodity, but has the same characteristics). If you bought and held an ETP like VXX (long the front two VIX futures contracts) during the full-year period of 2017, you would have lost 70%. A vast majority of that 70% can be attributed to rolling down the futures curve in contango. Buying and holding this sort of ETP in a non-volatile environment is worse than watching paint dry; it is more akin to watching paint peel.

There is another problem with buying and holding these types of investment vehicles, especially as the rolling of futures contracts starts in earnest about 2-3 weeks after the last roll. These investment vehicles are programmatic (they have to buy and sell specific futures contracts) and they generally constitute a large percentage of the futures contracts open interest. That means every professional in the business, or “the sharks,” know that “the muppets” have to trade and they know what contracts the muppets have to trade. Granted, very bad things can happen to professionals if in the middle of front-running the big ETP the price of the commodity spikes, and perhaps the futures curve goes into backwardation (the reverse of contango), but generally, things tend to work out better for the professionals.

Things worked out very well for professionals last week. While the large ETPs (USO and Barclays Exchange-Traded Note OIL) were no longer in the May WTI futures contract, they were in the June contract. When the May contract showed, the day before settlement that it could indeed go negative by a lot (closed MINUS $37.63 on April 20th), the June could indeed suffer a similar fate. Thus, the June contract crashed on Tuesday, falling intra-day 68% ($6.50 was the low). This resulted in Barclays terminating OIL and USO thrashing around desperately to get out of June and into July and August. USO filed with the SEC to diversify its underlying into to later contracts “other fuels”, becoming what Cantor Fitzgerald chief market strategist Peter Cecchini has called, “unanalyzable.”

Given the way disclosures are currently being given by the fund, it’s almost unanalyzable, because you don’t have a sense of what the weighting along the futures curve is. There’s nothing you can look at right now because you just don’t know how they’re going to move these things around.”

Unanalyzable is not a good attribute for products pitched as great ways for the general public to “participate” in physical commodities.

 

Investing involves certain risks, including possible loss of principal. You should understand and carefully consider a strategy’s objectives, risks, fees, expenses and other information before investing. The views expressed in this commentary are subject to change and are not intended to be a recommendation or investment advice. Such views do not take into account the individual financial circumstances or objectives of any investor that receives them. All indices are unmanaged and are not available for direct investment. Indices do not incur costs including the payment of transaction costs, fees and other expenses. This information should not be considered a solicitation or an offer to provide any service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Past performance is no guarantee of future results.

© 2020 SWBC. All rights reserved. Securities offered through SWBC Investment Services, LLC, a registered broker/dealer. Member FINRA & SIPC. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor, registered as such with the US Securities & Exchange Commission. SWBC Investment Services, LLC is under separate ownership from any other named entity. SWBC Investment Services, LLC a division of SWBC, is a nationwide partnership of advisor.

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