Tag Archives: oil

Sector ETFs Help You Avoid Single-Stock Risk

In a follow up to the previous posting on PowerShares’ suite of small-cap sector ETFs, the beauty of sector plays is that you can follow a trend without taking single stock risk.

For instance, if you think oil is going to go up in price you might want to purchase stocks of some oil companies. Let’s take an example from 2006 when oil was surging.  In this case, you bought BP, the formerly named British Petroleum, at the beginning of 2006. Over the course of that year BP experience some serious problems, such as a refinery explosion that killed 15 people in Texas. It later came out BP had suffered a series of deadly incidents due to poor safety standards. Then BP had two big oil spills in Alaska and managers were later indicted and fined for manipulation of the crude-oil and propane markets.  By the end of 2006, BP’s stock was flat but ExxonMobil had jumped about 30% on surging oil prices.

This is called single stock risk and the problem is obvious. You made the right call on oil, but you picked the wrong stock. You just happened to pick the oil stock that was subsumed with scandal. However, if you buy a sector ETF holding large-cap oil stocks, you get instant diversification because you own shares of many oil companies. You capture the upside in the oil prices and in this case, one bad stock has a negligible effect on the portfolio.

Daily Finance has a broader look at how to become a savvy investor in sector ETFs.

U.S. Oil to Change Roll Policy

Aha! The Wall Street Journal obviously read my interview with John Hyland about its take on the U.S. Oil Fund’s (USO) influence on the futures market and is fighting back. Or did someone read my post and get to Hyland?

OK. I might be giving myself too much credit. But then again …

I’m not quite sure what to make of the fact that the day after I spoke with Hyland, the WSJ reported that the exchange-traded product with $3.4 billion in assets will abandon its practice of rolling its entire oil future position in one day. USO now says it will renew the expiring contracts over the course of four days.

The New York Mercantile Exchange says that last Tuesday USO held 19% of all the crude for April delivery. Meanwhile, the ICE Futures Europe exchange says the fund holds 30% of its April contracts.

The Journal says the size of the fund was affecting oil prices and hurting the fund’s investors. With the fund announcing what day it would roll, oil traders would front-run the fund by selling the front-month futures contract before that date. This would push the price down, hurting the fund’s investors. With oil for delivery currently higher than the spot price, USO would then need to pony up more to buy the second month contract.

WJS says “U.S. Oil paid anywhere from a $4 to $6.10-a-barrel premium when it sold March and bought April futures contracts, as robust oil supplies and weak demand pushed down near-term prices relative to outer months.” It also reported analysts at Goldman Sachs published a note saying long-term holdings in near-term commodity contracts are “not investable,” citing the large roll cost. According to WSJ, the USO’s share price had fallen 71% over the 52-weeks ending Wednesday.

USO said it will continue to hold the front-month contract, as that is the structure of the fund.

USO Affects Futures Market

The U.S. Oil Fund (USO), an exchange-traded vehicle with $3.3 billion in assets, is getting so large it’s affecting the oil market, according to Carolyn Cui of The Wall Street Journal. Cui says “the sheer size of USO’s position, which accounts for about 22% of outstanding front-month contracts, is sending tremors through futures markets and contributed to oil’s dip below $40 a barrel in intraday trading Friday.” She says the volume of crude-oil futures on New York Mercantile Exchange was “nearly double the average volume posted so far this year.”

Most ETVs that track the oil market are commodity pools that hold futures contracts. While many investors think USO tracks the spot price of oil, it actually tracks the price of the future contract one month in the future. As the futures contract nears its expiration it must roll over the contract, that is sell the current contract and purchase the next month, or else take delivery of the oil. As oil prices sank from $145.29 a barrel in early July, the fund more than tripled in size, as investors predicted the price of oil would bounce. The National Stock Exchange says in December and January alone the fund received net cash inflows of $3.46 billion.

For more on USO see page 185 of ETFs for the Long Run.

Why didn’t the oil ETFs surge when oil spiked $25?

Oil prices saw the biggest one-day jump ever on Monday as the front month crude-oil contract rocketed more than $25 a barrel to $130 in midday trading on the New York Mercantile Exchange. By the end of the day, the October contract for light, sweet crude fell off its highs to close at $120.92, a 13.8% jump of $16.37.

So why did the oil ETFs and ETNs post percentage gains much less than half that?

· United States Oil (USO), a commodity pool which holds futures, leapt 6.03% to $87.62.
· iPath S&P GSCI Crude Oil Total Return Index (OIL), an exchange-traded note, jumped 5.6% to $64.57.
· Macroshares $100 Oil (UOY), which bet on the oil market through U.S. Treasurys, climbed 4.1% to $26.68
· PowerShares DB Oil Fund (DBO), a commodity pool which holds futures, rose 2.5% to $40.99
· The Energy Select Sector SPDR (XLE), which holds oil stocks, actually fell 1.8% to $70.

There were a multitude of reasons for the oil spike. Fears over the government’s $700 billion bailout plan and the potential inflation sent the dollar plunging. And lately, oil has been moving inversely to the dollar.

“Basically, there’s a strong negative correlation between the dollar and oil,” says Douglas Hepworth, director of research at Gresham Investment Management, a New York money manager. “It becomes a self fulfilling trading artifact. When the dollar is up, operators sell oil, and when oil is up, people sell the dollar. And the dollar was sold in the sentiment that if this new $700 billion dollar bailout is socialism, do we really want to hold dollars?”

In addition, oil fields in Texas and Louisiana are still shut down because of Hurricane Ike. Platforms are still out of commission in the Gulf of Mexico and companies need to check the pipelines to make sure they’re not leaking. These are coming back on line slowly. So, there was a real short-term squeeze on inventory and companies were tapping into the strategic oil reserve.

In addition, Monday, was the day the October contract expired. So, if you wanted oil for delivery on Oct. 1 you needed to get in the market. And if you wanted to not be holding, you needed to sell or close a position. This was the last chance for refineries and other oil companies to buy and get delivery next week. It created a short squeeze and sent the price of crude soaring.

At the end of Monday’s session, the November contract was scheduled to become the front-month contract, so some investors thought there might be a play to profit on here.

So, why didn’t the oil ETFs see a similar rise?

They didn’t own the October contract.

“USO along with the other commodities ETFs doesn’t own the contract up until the expiration,” says John Hyland, the portfolio manager of USO. So, while the October contract closed up 14.78%, USO owned the November contract which only rose 6.44%. At the end of the day, USO’s NAV was up 6.46%

Hyland says all the commodity ETFs had sold the contract one or two weeks ago. The commodities ETFs don’t hold the front-month contract until the expiration because it’s too risky. He says “unless you’re an oil company and you want to take deliver you would never want to hold them the last week. The last week is mostly trading by oil companies and revenue, someone who will actually get delivery.” If the ETF held the contract on Monday, it was going to have to take delivery of actual oil and none of them want to do that. Where do you store it?

So, it’s normal for the ETF to roll out of the front-month contract and into the second-month in the last two weeks to the movement.

“You won’t see anyone on the last day of trading a contract who is not in the physical market,” says Gresham’s Hepworth. “You basically play a game where you have to make or take delivery. You might occasionally see someone inexperienced who has a position on the last trading day. Well, they will never do that again.”

Hepworth says the October market was an illusion with just a few players playing a high stakes game of poker. The ETFs mirrored the real market, which was the November contract.

Anonymous sources said that high stakes poker game was being played by Chevron, ExxonMobile and BP. Rumor has it that BP was short and needed oil for its October operations and that the other two took them to the cleaners.