The easy way to catch the oil rally

ETCs invest in the future price of oil via futures contracts and are one of the easiest ways to invest directly in oil. Unlike other commodities, oil cannot easily be stored, meaning the options for investing in it are limited to buying the shares of oil-related companies or investing in oil derivatives contracts. Compared with buying the shares of oil giants such as Royal Dutch Shell (RDSB) and BP (BP.), whose returns are dependent on much more than the oil price alone, ETCs offer a better way to play the oil price. Instead of buying and holding oil company equities like an active fund, ETCs track the futures price of oil via derivatives contracts.

But that brings added risk due to the fact that your returns may be affected not only by the spot price of oil but also market expectations of what the price will do in the future.

However investors have been wading into ETCs since last year's dramatic price slump to take advantage of the recent uptick. Many are already taking profits amid the recent rally. But that does not mean you are out of time.

The case for oil

The price of Brent crude nosedived, falling as low as $27 (£18.93) a barrel in January 2016, down from $115 in June 2014. But since January it has picked up, with cuts to US production limiting supply and the price climbing back to over $40 last week.

Year to date the Bloomberg West Texas Intermediate Crude Oil Subindex (an index representing US oil producers) is down 0.8 per cent, but since hitting a low in February it is up by more than 30 per cent (between 10 February and 23 March 2016). The Bloomberg Brent Crude Index, which represents global crude oil markets, is up by more having returned almost 9 per cent since the start of the year.

Nitesh Shah, research analyst at ETF Securities, says: "We think there is potential for the oil price to continue to rise. The cuts in capital expenditure (capex) which took place last year have really started to bear fruit in terms of the reduction of production."

There is still a raft of oversupply issues which could hit the price of oil this year, including Iran's determination to build up production rather than cut, along with Libya's staunch refusal to freeze supply. However Libya's total generation remains small and last year's price crash is undoubtedly taking effect.

And although rising oil prices are good for ETC returns, they are also detrimental because of the costs of dealing futures contracts. A futures contract is an agreement to buy (and sell) something at an agreed price at some point in the future, so when an oil future matures the ETC must either buy new futures or take delivery of an enormous quantity of oil. As it does not do the latter it rolls the contract. But if the market expects the price of oil to continue upwards, the future price of oil will be higher than the spot price. That situation, known as contango or negative roll yield, means the ETC sells the maturing future at a lower price than it buys a new one.

Brent oil futures

WTI oil futures

Currently, markets are in contango. That will eat away at the returns from your ETC and means you do not get the return of the spot price. West Texas Intermediate Oil (a grade of crude oil used as a benchmark for pricing) is trading with a negative roll yield of 4 per cent which, according to Mr Shah, "says people are mildly bullish about where oil is going and that in the immediate future people expect oil to make a recovery". However, that cost of rolling the contracts is mitigated by the rising oil price which has risen by far more than 4 per cent, and means that ETC investors have still earned a positive return since the start of the year.

Futures contracts which expire at dates further into the future can reveal the temperature of the market and investors' expectations about the direction of the oil price. Yield curves, which show the expected price of contracts maturing at different times, imply that investor bullishness over the oil price might already be running out. The yield curve looks relatively flat, meaning investors believe the upside to the price surge might already have run its course.

"The WTI curve started at $26 but is now starting closer to $40," says Mr Shah. "That means all the optimism that investors had in that first month has materialised already and the price has increased. So people have become more bullish about oil prices but not as optimistic about levels as the rally we've already had."

Which ETC?

Two of the largest ETCs tracking oil futures are ETFS Brent Crude (BRNT) which tracks the Bloomberg Brent Crude Subindex and ETFS WTI Crude Oil (CRUD), which tracks the price of WTI crude oil. They are also the longest-running ETCs.

db WTI Crude Oil Booster ETC (XCT9) also has a reasonable track record and has performed in line with ETFS WTI Brent Crude Oil (CRUD). But at a size of $34.68m it is far smaller than the latter fund which could impact on the ease of buying and selling its shares.

Oil ETC performance

Source: FE Analytics, as at 24.03.16