There's been an extraordinary collapse in the price of oil in the United States with crude dropping below $1 a barrel, and at one point even going negative for the first time ever. pic.twitter.com/D7pRFL6et7
— Channel 4 News (@Channel4News) April 20, 2020
Article outline 1. Do OOO holders understand the ETF? 2. The alarming risks associated with OOO. 3. Is OOO even worth considering?
Why the hype around OOO, have investors got it wrong?
OOO aims to track the price of West Texas Intermediate (WTI) crude oil futures. That is OOO at a base level. However, you should never invest in ETFs, only knowing the base level. It seems some investors dove straight into the OOO ocean without checking for any sharks. Some investors thought oil is negative, it must go up, and if OOO tracks oil, then OOO must go up, right?
It is more complicated than that. Grab a seat. Because if you invested in OOO or you are interested in OOO, you will want to pay close attention.
First, what are futures?
A future is a contract. The contract allows someone to buy an asset (such as oil) at an agreed price. However, the asset, such as oil, is paid for and delivered sometime in the future.
How investors make money off oil futures?
Investors trade oil using monthly futures. Once a trader buys an oil future, they agree, on paper, to receive a delivery at the end of the month. However, traders do not want physical oil. Hence, traders buy oil futures with the sole purpose of selling them, before expiration, to make a profit.
OOO purchases month a’s future and then sell’s month a’s futures to buy month b’s futures. OOO does this to maintain exposure to WTI constantly. Thus you cannot look at each monthly transaction in isolation.
Thus, you can see there is more to investing in oil then simply buying and selling a commodity.
Investors need to know the risks!
- If those prices remain fixed and I buy May at $21.40 and sell May at $21.40 that is bad. Because I can only get 87% exposure to oil in June. $21.40/$25.40 = 87%.
- You can still make money in contango. However, May’s price would have to rise by 14%+ (to $25+) before it expires. Allowing you to sell May’s contract, buy June’s contract, and make a profit.
- If those prices remain fixed and I buy June at $21.40 sell June at $20.20 that is good for the short term. Because I can sell June, buy July’s contract and still make a profit. However, in the long-term, you do not want oil to go down.
- Backwardation explains why oil was a bad investment over the past 5+ years.
3) Uncertain oil crisis:
The future direction of oil is uncertain. Meaning extreme contango and extreme backwardation are happening. The volatility around oil is not going away anytime soon. Especially when the Russia-Saudia Arabia oil crisis is intensifying. Also, oil companies continue to produce oil even though there is no demand. Creating a massive demand-supply disparity.
When investing in ASX OOO, you need to consider
- What does the current futures curve look like (upward or downward) = Contango or Backwardation?
- Do you expect the price of oil during the month (spot price) to stay fixed, go up, go down?
- How long do you expect to hold the investment?
Thus, you can see there is more to investing in oil then simply buying and selling a commodity. If you are going to invest in OOO, you must understand all the risks. Just like Warren Buffet advocates, “Invest in businesses YOU understand”. Hence, invest in ETF’s YOU understand completely.
Is OOO worth the investment?
Before I start, I am obliged to remind our viewers that this is not advice only general commentary from my extensive research in this area.
Yes, OOO offers simple exposure to the oil futures. However, it is simple for the investor because the fund managers are dealing with difficult numbers.
Personally, I would invest in OOO for the long-term once there is enough evidence to support an oil recovery. Because Contango would work in my favour.
All in all, OOO is an excellent short-term investment if your timing is impeccable, and you understand contango and backwardation. However, if you miss time the investment, you could be badly burned. Thus, I would suggest diverting your attention to these two oil stocks, which are safer and are poised for a breakthrough. Especially, while the oil outlook is uncertain.
Here is our free, uncomplicated, and extensive ASX portfolio
Want access to free, uncomplicated, and smart COVID-19 Strategies then click below?
The information above should not be taken as financial advice. Youth Investment Group has no liability for personal financial interests or investment decisions. You should make your own investment decisions based upon your own research and what you believe is best for you.
Written by Patrick McLoughlin, Senior Manager of YIG.