Oil ETFs Get Boost from Futures Backwardation Shift
October 25th, 2011 at 2:01pm by Tom Lydon
Oil exchange traded funds have jumped this week as the futures curve for West Texas Intermediate moved into “backwardation” for the first time in about three years.
“This means means index investors (mainly in the USO ETF) whose returns have been compromised since late 2008 despite oil’s rise from $30 to $90 a barrel, are finally making money on the ‘roll yield,’ as they sell the front month and buy later months,” Tradition Energy analyst Addison Armstrong said in the CNBC report.
The oil ETF and some other commodity funds buy futures contracts to get exposure to markets, rather than holding physical commodities. Instead of taking delivery, these ETFs “roll” the contracts to maintain exposure. Therefore, they don’t track the spot price investors see quoted in reports.
When the futures curve has an upward slope, markets are said to be in “contango.” This can drag on oil ETF performance because the longer-dated futures are more expensive, and the funds lose money on the roll trade. However, when markets are in backwardation, the trade can provide a lift.
The cost of WTI crude for immediate delivery is higher than forward contracts for the first time since the start of the financial crisis in the fall of 2008, the Financial Times reported Tuesday. Backwardation points to a close supply and demand balance. “The speed and magnitude of the shift into backwardation has left the oil market reeling,” the FT reported. “Trade volumes at Nymex, the New York-based exchange home of WTI, spiked on Monday to the highest level in nearly six months as macro hedge funds that were betting that an economic crisis would bring a deep contango exited their trades en masse.”
The move into front-month oil futures this week caught many traders by surprise, Reuters reported. “The shifts highlight a change in sentiment, said John Kilduff at Again Capital.
According to the Energy Information Administration, U.S. oil stocks have dropped around 8% year-over-year, falling to 332.9 million barrels.
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Max Chen contributed to this article.
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