The on/off Middle East crisis is on again this week, sending up oil prices in response. Dated Brent – a key benchmark based on North Sea oil – is above $100 for the first time since July at the time of writing.
Every time oil moves in a significant way, it raises the question of how best to play higher prices. One answer to that depends on what kind of move you expect.
Dated Brent – which is the benchmark that you tend to hear most – reflects what is happening to demand for physical oil right now. It is an example of a spot price, meaning the price to complete a commodity transaction immediately. In the case of Dated Brent, the buyer is buying a cargo of oil that will be loaded on a predefined date in the next few days or weeks.
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However, traders also pay close attention to futures prices – the price of a contract to buy or sell oil at some point in the future. That date may be in one month, three months, six months or further ahead. There is a long chain of contracts which can stretch out for years, but most activity is in the ones closest to expiry.
As an individual investor, you can’t trade physical oil directly. You could trade oil futures, but using an exchange-traded fund (ETF) such as WisdomTree Brent Crude Oil ETF (LSE: BRNT) is simpler. Yet this distinction between spot and futures prices is still important when using an ETF.
How oil ETFs work
While ETFs for gold or other metals often hold physical metal and reflect the spot price, oil ETFs have traditionally worked by buying futures contracts for near-term months. As each contract gets close to expiry, the ETF sells its existing position in that contract and rolls over into another contract a month or two further out.
So the ETF will reflect the trends in near-term oil futures. It will also gain or lose from a less obvious source of return called roll yield. If futures prices for the nearest months are higher than those for more distant months, the ETF will be selling higher and buying lower each time, and will earn a profit from doing so. Conversely, if prices for nearer months are lower than more distant months, the ETF will be selling lower and buying higher, and the roll yield will be negative.
If – as is often the case in a crisis – spot prices spike by much more than futures, a typical oil ETF will not rise by as much as the spot price does. However, the new-ish Onyx Spot Return Crude Oil ETF (LSE: OIL) takes a different approach. It holds very short-term daily Dated Brent futures, which it continuously rolls over. As a result, it is a closer proxy for the spot price. This product launched in June and has beaten traditional ETFs since then (see chart). Whether it keeps doing so depends on whether spot prices remain much higher than futures and on whether the futures roll yield is positive or negative. Regardless, it’s interesting to see a new way to trade immediate shocks to physical oil prices that relies less on shifts in futures.
(Image credit: Unknown)
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.