Avoid speculative investments in crude oil futures ETFs

With the recent dramatic drop in crude oil prices, the May WTI crude contract went into negative territory to -USD$40.32 on its worst performing day, sending shockwaves to investors worldwide.

There is a strong tie between crude oil prices and economic activities. For those without any crude oil investments, the sharp fall in oil prices may as well be another news story, while car owners are concerned if petrol will be cheaper in the near future. Some investors may invest in related financial products, with the anticipation of profiting when oil prices bounce back.

Crude oil futures ETFs are a type of financial product through which we can invest in crude oil. Primarily through investment in crude oil futures contracts, crude oil futures ETFs track specified underlying crude oil futures index. Investors with experience in trading ETFs will know that ETF prices are directly impacted by the performance of the underlying index. Given crude oil prices have always been volatile and are now in a low position, investments in crude oil futures ETF is not without risks. In addition, investors may face operational risks of futures ETFs, such as that from rolling futures contracts.

To track the specified underlying index, a futures ETF manager would sell expiring current futures contracts, and roll to futures contracts with a later expiration. If the price of the longer-term futures contracts is higher than that of the expiring futures contracts, the amount gained from selling the expiring contracts will not be enough to cover the cost of rolling the same amount of contracts with longer terms. Although such rollover may not incur immediate losses or profits (except transaction costs) to the ETF, as expiration approaches and the price of the futures contracts moves down to converge to the spot price, such a trend may induce losses to the ETF and have an adverse impact on its net asset value. At present, the price of long-term crude oil futures contracts is higher than that of short-term (such as next month) crude oil futures contracts, possibly having a negative effect on the performance of crude oil futures ETFs.

Futures ETFs can invest in short term or long term (i.e. 12 months) futures contracts. The mix of futures contracts typically mirrors that of the underlying index. However, things may operate differently under exceptional market conditions. For instance, if the fund manager expects the price of next month crude oil futures contracts to fall to a negative value, thus bringing losses to investors, the manager may rollover to crude oil futures contracts with a later expiration. However, such a rollover may cause the crude oil futures ETFs to perform differently from the underlying index; and that next month’s crude oil futures contract price trend may not be reflected in the ETF’s price.

I’ve witnessed many ups and downs of crude oil prices in my lifetime. The international crude oil futures price can go up to over USD$100; in 2008, it even rose to beyond USD$140. Perhaps many investors think it’s only a short term phenomena to have crude oil prices drop to a negative value, and that the market will eventually bounce back. However, after the occurrence of COVID-19 this year, maybe we should start getting used to expect the unexpected.

If you think that investing in crude oil futures ETFs can be complicated, you’re not mistaken! Crude oil futures ETFs are definitely not for inexperienced investors. Investors should take note that, if the price of the futures contracts that the crude oil futures ETF is tracking drops to a negative value, theoretically, the net asset value of the ETF too can drop to zero.