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Duration: 3:10

Contributor: WisdomTree Europe

Level: Beginner

This lesson focuses on Oil ETPs and what investors should be aware of when deciding to invest in these products.

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Study Notes:

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.

Prices

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.

Other Factors

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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Disclosure: Wisdom Tree

WisdomTree is not affiliated with Interactive Brokers LLC

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Academy that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Academy are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Wisdom Tree and is being posted with permission from Wisdom Tree. The views expressed in this material are solely those of the author and/or Wisdom Tree and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Disclosure: Forex

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

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