An Introduction to Oil ETPs
For many investors, gaining exposure to crude oil prices is not always a simple task.
Physical investment needs operational know-how and expensive infrastructure and using derivatives can be complex.
A simple alternative is investing in oil exchange traded products, or oil ETPs.
Let’s look at the crude oil market and see how ETPs is fit in:
There are many different grades of crude, but two oil grade benchmarks dominate the global market:
- Brent Crude and
- West Texas Intermediate.
ETPs work by tracking total return indices underpinned by oil futures, typically based on the two major benchmarks.
Oil Futures Contracts
An oil futures contract is an agreement to buy a specified amount of oil on a future date at a set price.
Contracts vary in duration, with maturities ranging from one month to three years or more.
At expiry, the contract can be settled physically by delivery of the underlying oil barrels, or financially based on the value of the contracts at expiry.
For any given maturity, futures prices are a function of:
- The spot price,
- Prevailing interest rates, and
- Oil storage costs.
An ETP’s price reflects what’s known as a total return exposure to the underlying oil futures investments after fees and costs are deducted.
Total Return Components
The total return has three components:
- The price return reflects price movements in the underlying futures contracts.
- The roll yield is the loss or gain caused by reinvesting or rolling a futures contract that’s nearing expiry to a longer dated one.
Rolling is necessary for an oil ETP to maintain constant exposure to oil prices, and
It’s important to recognize the roll yield can be negative or positive.
For an investor who is long, the oil price rolling into a longer dated futures contract that’s priced higher, known as contango, the investor incurs a loss.
And if the new contract is price lower, known as backwardation, the investor enjoys a gain.
- Collateral yield, which comprises the final component of total return, is the interest earned on the cash value of the investment.
That is why the returns from an ETP can be different from those quoted by mainstream sources.
An additional factor is currency exposure.
Because crude oil is priced in US dollars, so too are oil ETPs.
That means non-dollar investors inevitably take on a currency risk.
To mitigate this, investors can buy currency-hedged oil ETPs.
Oil ETPs can be traded directly through online trading platforms and brokers or through financial advisors.
They provide a simple, cost effective way to acquire a total return investment in oil futures whilst avoiding the complexity of futures trading.
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There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.
Disclosure: Leverage ETFs
Complex or Leveraged Exchange-Traded Products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products. Learn more about the risks here: https://gdcdyn.interactivebrokers.com/Universal/servlet/Registration_v2.formSampleView?formdb=4155