Oil stocks, Contango and Backwardation

Q. How can I get exposure on Oil?


A: Apart from buying securities in Oil stocks other ways to invest in Oil are as follows:

Oil futures - you enter into a derivative contract based upon the price of oil. Contracts are typically traded in 1000 barrel units, so represent a substantial stake. There is minimal counterparty risk as these are exchange traded. However, they are margin traded and discipline and careful understanding of the issues of margin is required. As margin traded derivatives, there are financing charges to be paid on the 'purchase' side of the contract - these can be quite draining, e.g. LIBOR + 3%. Long dated contracts are highly illiquid, it may be more appropriate to purchase short dated contracts (e.g. 3 months) and then roll them (sell and buy a later one) after a period.

Spread betting - Much the same as buying futures directly - but more convenient sizing is available, and these are fully tax exempt. A larger market spread may exist if 'rolling' from one contract to another. Financing charges need to be paid as for futures. Counter party risk may exist with respect to your bookmaker - if they go broke, you may lose regardless of the underlying investment strategy.

CFDs - As for spread betting, but not tax exempt.

ETFs - You buy shares in a fund, into which cash is put. The cash is then used as collateral for over-the-counter derivatives (like futures) based on the price of oil. All oil ETFs track the futures returns as it is impossible to invest directly in the spot rate. The price of the shares tracks the price of oil. There are small management charges, and a small net interest charge (representing the difference between the interest earned on the cash collateral, and the financing charges of the derivatives). Counterparty exists, but risk is low, as the oil ETFs tend to enter into their derivatives with oil companies - e.g. the popular ETF 'CRUD' uses Shell as its derivative counterparty. The largest Oil ETF listed in London is ETFS Crude Oil (CRUD) which is priced in dollars and has an annual management fee of about 0.49%

Q. Any thoughts on Oil stocks?

A: The rule of thumb on oil stocks is to be very respectful of market trends as you only learn slowly over time that the down stream businesses of the oil majors can suffer during periods of high prices when their 'upstream' extraction and refining businesses are obviously booming.

Explorers have more value adding opportunities but the majority of them are run by rogues who never deliver so it is quality filtering and luck that you need plus only play this game when us oil stock levels are looking dodgy and both gas and oil prices are on an uptrend.

Having said that the oil prices of exploration companies like Venture Production are more correlated with the oil price than those of the big refineries like BP or Royal Dutch Shell. Bigger established oil companies like BP and Cairn Energy with substantial oil reserves also show better correlation with the oil price than smaller caps, where much depends on the outcome of their drilling programmes. Also, a bad trading session for the oil price is likely to have a corresponding negative effect on the oil majors and as these stocks account for a major chunk of the FTSE they are likely to pull the FTSE index down with them.

Long term what matters in oil is the price assumption that the oil majors use for their own planning purposes and not the spot price of $64. This was $18 then $24 - 28 and I don't know what it is now but you can find out by exhaustive reading of their annual reports and analysts write ups.

Gamblers should buy shares in the engineering firms and engineering consultancies according to Mondays FT (Fluor, FLR, at $86 for instance) as new refineries need to be built. No need to buy these before market stops wobbling.

So in a nutshell -:

Large Oil Companies - Relatively stable blue chip companies with large reserves, and they tend to be integrated - i.e. they operate all parts of the chain, including transport and refining. Offer less risk than buying oil directly, and generate an income with quite generous dividends (rather than you having to pay significant finance charges). Oil companies can range from giants such as Shell and BP through mid-sized businesses such as Cairn to oil 'minnows' such as Tullow Oil.

Oil Exploration Companies - High risk, tend not to track the price of oil very well - but quite nice if you like playing the lottery (except with rather better odds). On most do not expect a dividend unless they hit the jackpot! (These companies seem to like the London Stock Exchange - there are loads of them, many having moved from all over the world to the UK to acccess the London stock exchange).

Oil Royalty Trusts - companies that receive royalties based on oil extracted from their land. Share prices have taken a massive beating recently. Tend to pay a very generous income based upon the current price of crude oil. Track the price of oil reasonably well, although depletion of reserves may be an issue if you plan to hold long term. (Need to look to the US and Canadian markets for these though - which may be troublesome though some of the budget UK brokers).

Note: Bear in mind that the odds stand at about 4:1 against a speculator finding oil. So 3 out of 4 dips into the market could lose you 80% ish. Even though I have a very small holding in RKH, I am aware that there will be more fund raising along the way which produces peaks and troughs. There is also a lot of infrastructure to be paid for. Take a look at CNE way back when it hit a big find in the Indian ocean (1994 I believe) and check the chart up to when they sold out. If you hit one of these biggies then you need to play the momentum with something fairly fast responding like a moving average or MACD. Keep selling the pullback and buying back in.

I don't invest much in oil stocks because if a well is dry the price goes down. For every winner there are 10 losers (or some such, that's a guess). It's the same in biotech, so I avoid. If they are relying on one particular thing coming together, yes it can take off, but it more than likely will fail and you pay the price for it. Those that generally tend to do well in Oil and Gas stocks are either involved in the industry (specifically in exploration) or know these people well enough to be steered into the 'right' stocks. If you can catch one of those oilers on the move there is much money to be made but if you are last with an order in - you can end up feeling very silly. The market makers nearly always turn off automatic dealing and then it's a lottery as to who gets through to their broker first. Then the dealer has to get through to a market maker and there's nearly always someone who is faster than you.

Q. What is Contango and Backwardation?

A: Contango and backwardation are industry terms that are applicable to the futures commodity markets. Contango in practice means that the commodity price for future delivery trades above the 'spot' price (that is quoted for immediate or near-term settlement) while backwardation refers to market situations where the price is lower than the 'spot' price.

In other words a 'contango' situation occurs when oil prices for future delivery are higher than the current oil price. This phenomenon has caused erosion on funds that invest in near-term futures contracts based on the price of oil, so ETF investments may not be as simple as they seem. In practice, the consequences of this is that contango results in extra costs that reduce the overall return on investment product thag tracks indices using futures. This results in a negative roll yield. Do consult a stockbroker if you are keen on investing in ETFs.

For example, a crude oil contango situation happened in the first half-year of 2009 where market participants and oil companies stored many millions of barrels of crude oil in tankers in an attempt to make an easy gain. This created a market ambiguity which persisted for the remainder of the year and explained the discrepancy between the increase in the spot oil price and the various tradeable instruments for crude oil like ETFs. While the physical spot oil price fell to about $34 and peaked at the $80's levels, longer-dated futures reflected more modest price increases.

Backwardation on the other hand is a rare phenomenon in the world of futures trading but usually indicates a market where there is uncertainty in the immediate future on the supply or situations where there is a sharp increase in near-term demand. In this instance, future prices are lower than a commmodity's spot price which creates a positive roll yield for market participants. In practice it means that buyers would prefer to have delivery of the commodity now - even if they could end up paying less for future delivery. For an investor in a commodity-based exchange traded fund this is usually positive news as it may allow fund managers to roll futures commodity contracts (i.e. sell and buy new contracts) at a discount since the expiring contracts will trade at a premium to the longer-dated contract being acquired.

Q. How does Contango affect ETF's prices?

A: OK, to explain this let's pick USO (which is the highest volume Oil exchange traded fund). USO does not own any physical crude oil, it just buys futures contracts... USO uses those future contracts to hedge itself - and, since positions have to be rolled forward regularly to prevent taking physical delivery, it is not easy to outperform the market prices. This is because with Contango you have to pay a premium to move into the next monthly contract so a profit can only be realised if the positive price movements are greater than the losses generated by the rollover itself (i.e. the premium paid to remain in the position). So while to many people the low price of oil may look like a great buying opportunity, the current state of the market means, more than likely, they will generate a loss just because of the roll. The conclusion, is that USO is not a direct play on the spot price of crude oil, it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward. Check out this site to see for yourself the extent to which Contango will affect future oil ETFs. Thus, in Contango, it is probably better to buy shares of companies with oil 'in the ground' so they do not need to pay the high forward premiums (which tend to be connected to storage costs).

Q. Contango means that in a rollover from say Mar to May a contract can lose 15% if the front month price of oil stays the same due to the wide contango...

CRUD is US Light Crude March Contract underlying index play
OILB is Brent Crude March Contract underlying index play

Both rollover to May contract week after next so will lose 15% if front month price of oil stays the same due to the wide contango:

Mar 2009 40.18
May 2009 48.66

A: LOIL won't necessarily drop 10-15% on the rollover dates. What will drop though is how many barrels of oil you have in your LOIL investment. You have to sell all your March-2009 barrels for $40 (as you can't take delivery as you have nowhere to store the physical!)and buy May-2009 barrels at $46 over 5 days as in post 172. So you get 10-15% less barrels but the price of LOIL remains the same as May-2009 barrels are currently worth 10-15% more than March-2009 barrels so the net effect is zero. If the May-2009 price of oil subsequently then falls to $40 that is when your LOIL investment loses it's 10-15% (actually 20-30% due to the 2x leverage).

If you want to play an oil price rise, use CRUD: don't use LOIL because due to the gearing you lose more on the dips and don't get back to par when the oil price does. Even with CRUD, you lose on contango when the current future expires and is rolled over to the next month. To reduce the effect of contango, use a forward contract (eg: forward petroleum) as these buy three months forward and roll over further out where the effect of contango is less.

By May, OPEC may have the oil market under better control and the spot price could be higher or lower than $46 by then, nobody knows!.

P.S. Note that Contango is an abnormal situation in the futures markets. Normally prices in the future are lower than the current price (a condition known as 'backwardization'). The super Contango is most likely being fueled by the credit crisis and the need of companies to produce as much product as they physically can to generate cash. The Contango situation would normally create an incentive to delay production to a future date, and generally supports upward pressure on short term prices as such production is delayed.

Q. I am long on Mar exp (18/02) but the Apr spread is some $6 odd higher - surely the gap has to close before Mar expiry date?

I use City Index for day trading, and although i have bought US crude on spreadbet before, I can't recall the actions of the quotes around expiry time...to clarify, I am long on March expiry (18/02) but the April spread is some $6 odd higher - surely the gap has to close before March expiry date? If it doesn't I will be at a substantial deficit if i choose to rollover option...I'm long @ 36.06 and want to buy continually the lower it goes, but with expiry date coming up, I don't want to see those purchases rolled to April @ some $6 higher!!! Have I missed something, or am I wrong?

A: You missed Contango. The gap doesn't close I'm afraid (and often widens at the moment)...Your bet is closed at the mid-spread for March, and then re-opened at the mid-spread for April, result is you gain nothing but are opened at the higher price. And that's the problem with trading crude!

Q. Do you know of any product that tracks the oil price without it being open to contango and backwardation?

I'm long on a ETF tracker which tracks oil but am still losing even if oil is moving up...

A: It would be ideal to be able to buy a product based on a continually rolling oil price; but this doesn't exist, because the oil price isn't continual and all oil ETCs track the futures returns as it not possible to invest directly in the spot rate. ETFs like CRUD, OILB or OILW get round the problem of continually having to buy sell contracts but all these products bear the risk of contango, where it is easy to end up out-of-pocket, in other words you end up losing money even though the oil spot price is rising, when there is jump in price from the current contract to the next. The trouble is that contango is a result of a general consensus that oil will rise, it's not just you that thinks that, everyone else does too!

The ETFS crude ETF (exchange traded fund) does not buy or hold the physical commodity but buys futures instead, and rolls over from an expiring contract into the next on expiry: in respect of oil sometimes the price of the new futures contract is higher (Contango) and sometimes lower (Backwardation). With Contango, the ETF has to bear this higher price which adds to the cost, so over time the ETF price change will not match the oil price change. With backwardation, this runs in favour of the ETF price. Therefore, when using a crude oil ETF as a proxy for the price of crude, the loss (or sometimes gain) from this rolling over should be taken into account.

For instance the rollover from Jan-09 to Mar-09 was very bad for LOIL (ETFS Leveraged Crude Oil), and good for SOIL (ETFS Short Crude Oil), due to Mar-09 price 10% higher than Jan-09. The Exchange Traded Fund lost 10% compared to someone who could actually take delivery and store the black stuff. The 2 month contango seems to be narrowing slightly recently, but May-09 is still 8% higher than Mar-09 which will be bad for LOIL if it stays like that when rollover takes place in 6 weeks time. If the contango stays so high it won't matter if we reach $100 in 5 years time because LOIL could lose all the gains in the rollover cost/spread.

Personally, I would not at this time want an ETF that tracked the oil price by holding the physical commodity, as in my view, the price is still in a downtrend; so holding such an ETF would lose money. More so, holding a long futures based ETF would be bad at present as crude oil is in extreme contango, and you could lose 30% in a year even if the price of crude stayed the same the whole time!

ETF Valuation Date

Delivery Contract








Mar-09 / May-09








May-09 / Jul-09








Jul-09 / Sep-09








Sep-09 / Nov-09





The table at the top illustrates the rollover method of this LOIL (Leveraged Crude Oil). This takes place every 2 months over a 4 day period.

To minimise the effect of Contango on a long oil position you could for instance buy forward petroleum (FPET) as this buys 3 months forward futures where contango is far less (this is not a recommendation to buy FPET!). You might also consider investing in NYSE:DBO (PowerShares DB Oil Index Exchange-Traded Funds Trust) or NYSE:OIH (Oil Services HOLDRs Trust due 12/31/2041) to track the price of oil without losing out on rollover due to contango.

This is not to say that these instruments are perfect and guaranteed to always follow the oil price. DBO tracks an oil index using futures as does CRUD and LOIL, with the difference being that DBO selects which future to rollover into by picking the one up to 13 months forward that has the least contango (or most backwardation). However, that is at that time: i.e. simple contango/backwardation. The real figure is not known until it happens, so whilst it picks the optimum one at rollover, the real result may still favour the simple strategy of rolling over the expiring contract to the next month's. I believe OIH to be an Oil-related exposure as it invests in a set selection of oil services companies (not oil itself, so be wary they may not always go hand in hand), which is substantially cheaper than Crude. Because although you can buy spot crude at around $40 now, there's no way (for the average person) to store it. And you will find you have to roll it, at a higher and higher cost.

Of course there's a big difference between short term/daytrading and even medium term trading of oil when fear/economics/politics all combine!

Q. How can SOIL and LOIL be down at the same time, something wrong there?

Am I missing something or have they just increased the spread on both... Perhaps AIG clawing some cash back ???

A: Contango/backwardation results from the rolling over of futures contracts at expiry and is a function of the ETF not that of any index, sub or otherwise. So if CRUD is constructed using futures (which I believe it is), then Contango/Backwardation results will still affect the prices.

With long and short exchange traded funds such as SOIL (ETFS Short Crude Oil) and LOIL (ETFS Leveraged Crude Oil) it often happens that both will be down or both up at the point of a trend change. With a closed end fund, this can be due to supply and demand, and with open ended funds, it could be due to interest being added or maybe a technical issue concerning pricing. I've not been able to arbitrage this, but then, I haven't tried! AIG are not involved in the pricing. You may be right about the spread too: it does jump around at times particularly at inflexion points.

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