Why Trading Oil Became So Sticky

A change in the futures market has made the crude market devilishly tricky, according to a recent report. Constable explains.
By Simon Constable ,

Trading oil has always been a tricky business, but a decade ago, things changed to make it downright perilous. 

It wasn't that it became more volatile -- the crude market has always been choppy. Rather, the returns from investing in futures became disconnected with the real market. Here's the detail of what happened and how you can avoid the pitfalls.

The energy market became increasingly oversupplied, which in turn led to an unfavorable flip in how the futures markets for the energy perform.

"[From 2005 through 2015,] it was extremely difficult to mimic the underlying spot market by investing in oil futures," according to a recent report titled Understanding Oil Investing, by Ludwig Chincarini, John Love, and Robert Nguyen, all at United States Commodity Funds Investments. Among other products, USCF runs the United States Oil exchange-traded fund (USO) - Get Report  , which holds futures contract for light sweet crude as well as cash.

In short, the report finds that futures prices didn't track the market spot price for oil closely enough. The so-called spot price is what it costs to buy crude for immediate delivery.

Such a problem means that even for those who understand what's going on in the murky global market for crude can't necessarily profit from it easily.

Storage costs

It's happening because of the need to cover storage costs for the global crude surplus.

"When you are oversupplied you need to induce storage economics," says John Dowd, portfolio manager of the Fidelity Select Natural Resources Portfolio (FNARX) - Get Report . In simple terms, that means when the world is awash with oil and you buy a contract for future delivery of the fuel, then you need to pay for the storage until it's shipped to you.

It also means that every time one front-month futures contract is rolled forward to a longer-dated one there is an extra cost to the trader. Rolling the contract involves selling one shorter-dated contract and simultaneously purchasing a later-dated one.

Over time, the costs eat into potential profits. For instance, at the time of writing, the November-dated contract on the CME trades at a 71 cent premium to the October contract, or 1.6%.

That 1.6% cost is for rolling just one month. So if you rolled one contract every month for a year, you'd have even bigger costs eating up your capital quickly even if the price for oil didn't change.

It wasn't always this way

The last decade has been something of an anomaly for the oil market.

"When you don't have enough oil in the market, then the front-month futures price gets bid up a bit," says Dowd. This little bit extra is dubbed the convenience cost. 

In a tight, or not oversupplied, market, oil buyers are willing to pay more for oil that is available for immediate delivery. Indeed, that was once a norm in the market.

"If I am long August contracts and I want to buy September ones, normally there would be a discount from one month to the next," says Victor Sperandeo, a Dallas-based commodity trading advisor at EAM Partners LP. In other words, that would be the opposite of the current situation in the market.

In normal markets, the discount from rolling over the futures makes it easier to make money simply because capital isn't being eaten away by the costs.

What to do?

How to trade oil depends on the structure of the futures market prevailing when you want to buy. But the authors of the paper worked out a strategy.

Traders should buy crude futures only when the price of the front-month contract exceeds that of the longer-dated contracts; otherwise, stay invested in cash, the authors of the 'Understanding Oil Investing' research paper recommend.

That strategy "has provided significant excess returns historically," the paper states. That is to say, it has been profitable versus a storage cost-adjusted benchmark of spot crude prices that the authors developed.

Right now, with near-dated futures prices below those of longer-dated contracts, investors should clearly remain in cash.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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