CE Course: An in-depth look at commodity ETFs

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September 2011 brought back bad memories of Lehman Brothers’ bankruptcy. Against that backdrop, it may be premature to look positively on any asset class. And this is perhaps particularly true of commodities—especially oil.

Lack of leadership continues to worsen the outlook for the global economy. Add to that recurring systemic risk and it’s easy to see why commodities recently underwent a pullback that makes the downside in equities seem tolerable.

If the remainder of 2011 resembles late 2008, renewed hope should materialize in the form of G-20 leaders rushing to the rescue. So, as an academic exercise, let’s look at 2008 and the first half of 2009 to get a sense for how things might play out.

Back in 2008: Bear Stearns is rescued in March; oil shoots up into early July; Lehman Brothers goes bankrupt in September; and the world’s economy heads toward the edge of the cliff before regrouping in March 2009.

And in 2011: Equities see their year highs in early spring; and the European debt crisis reclaims centre stage by summer, resulting in renewed fears of systemic risk due to European banks’ exposure to weak sovereign bonds.

Beyond the obvious—volatility was high then, and has regained significant altitude lately—the following is worth noting:

• The price of oil in 2011 neither reached the levels of exuberance seen in the early part of summer 2008 (surpassing US$140 per barrel), nor corrected to the depth seen in December 2008. If you anticipate a renewed disaster scenario, steering clear remains the way to go.
• Gold and silver prices have risen sharply since 2008, benefiting from the safe-haven status of gold in particular, with silver prices reflecting an upward trend in commodities in general. The status of commodities as a hedge against further U.S.-dollar devaluation helped this trend along. This hasn’t prevented a significant correction of late, the effect of which was magnified for silver.
• Natural gas continues on a track very different from that of 2008, thanks in large part to controversial drilling techniques, such as hydrofracking, that turned on massive new supply. In addition to closely monitoring hurricane season for gains related to supply disruption, market participants in late summer and fall focused on storage and weekly inventory reports to gauge the direction of prices. Seasonality considerations have solid impacts on prices, and right now temperatures are bound to drop, boosting demand and causing prices to rise.

ETFs in play

Investors looking to access commodities via ETFs can use:

• Bull+ or Bear+ (depending on whether they are bullish or bearish on the underlying commodity) ETFs, with 2x leverage (daily reset), which typically provide near-month futures contract exposure to crude oil, natural gas, gold bullion, silver, or copper.
• Single Long ETFs, or Inverse ETFs, providing exposure to either near-month future contracts on the underlying commodities, or, in the case of crude oil or natural gas, exposure to winter crude and natural gas. These ETFs are meant to blunt the negative effect of contango on front-month contract rolls by accessing futures exposure further along the futures curve. (Contango refers to market conditions where the price of a forward or futures contract is above the current spot price.)
• Spread products (long oil/short natural gas or long natural gas/short oil; long gold/short silver or long silver/short gold).
• Broad commodities exposure through actively managed, commodities-type baskets.

ETFs in these categories include

• 2X leverage (daily reset) ETFs: HKU/HKD; HBU/HBD; HZU/HZD; HOU/HOD; HNU/HND (Horizons)
• Single/Inverse ETFs: HUK; HUZ; HUC; HUN; HIO; HIN; HIB; HIZ (Horizons)
• Spread ETFs: HON/HNO; HBZ/HZB (Horizons)
• GAS; CBR; CGL (Claymore) ZCE; ZCA; ZCB; ZCP (BMO) IGT (iShares)

The trouble with oil

In the early part of 2008, despite signs the housing bubble would burst, oil prices were marching upward. As shown in the chart “Oil prices rose,” (CL1 is a composite of the 1-month futures contract for NYMEX crude oil), and magnified by the leverage (2x, daily reset) of HOU (HorizonsBetaPro NYMEX Crude Bull+), the rise in oil prices was impressive. Its significance wasn’t lost on regulators, who were worried at the time that crude price speculation would represent significant future risk.

Oil peaked in early July 2008, but as the economy went into free fall, crude prices fell rapidly. One-month futures trade at a premium to the spot price. So, when the one-month contract reaches spot status, it has effectively lost that premium, and the proceeds from its sale are not sufficient to buy the same number of futures contracts for the next month. These also trade at a premium to spot—as long as the contango context persists. Hence, the sale yields less than what is required to buy the same underlying exposure (also known as negative roll yield).

In 2008, there was a sharp rise in daily volatility in H2 relative to H1. The futures curve moved from backwardation (there were stronger spot prices relative to futures prices, looking to draw supply out of storage) to contango:

These attributes—sharply higher daily volatility, coupled with an upward sloping futures curve—would soon prove an insurmountable hurdle for returns via an ETF such as HOU that features 2x leverage and daily reset. This is shown in the chart “Oil price recovery,” which captures early December 2008 (oil bottomed mid-December) to mid-2009 (by then spot prices had regained considerable ground).

Unfortunately, even for non-leveraged ETFs, contango proved a remarkable challenge to keeping up with spot-price gains. This is because to stay in the trade (remain long), these ETFs lost the premium at which the front month contract traded relative to spot prices every month. To stay on board, the funds kept on rolling their exposure, over time in fewer and fewer contracts. This proved extremely frustrating to many who had correctly expected crude prices to recover strongly from late 2008 levels.

Despite the investors making the right call, the available market instruments proved ill-suited to the task of capturing the related expected returns, a result of the high volatility (leading to leverage compression) and steep contango market backdrop.

Attempts have been made to mitigate the drag represented by the front-month rolling methodology in a contango market. Options include picking a different contract on the curve that reduces the number of contract rolls, or seeking to identify the cheapest-to-own contracts. However, the further out the curve an investor goes, the less she benefits from strength at the spot-price level (to which front-month futures contracts provide greater traction and correlation).

As oil was peaking in early July 2008, the assets under management of the Bear+ NYMEX Crude Oil ETF significantly surpassed those of the Bull+ NYMEX Crude Oil ETF. This shows that instruments providing the ability to bet against a further ongoing upside in the commodity could dampen a continuation of the price increase of that commodity.

Two-times leverage reset on a daily basis is very different from 2x leverage over a longer time period. The greater the daily percentage changes, the greater the potential for effective leverage over that longer time period to be compressed, or reduced. As leverage goes down when the price of the underlying commodity rises, and up as it declines, the reset back to 2x forces buying on strength and selling on weakness. This is a positive in a trending market but results in leverage compression in a directionless one.

A shorter holding period is strongly advisable when expecting or experiencing greater volatility of the underlying commodity. This serves to mitigate the risk of leverage compression. As well, the higher the contango context, the shorter the desired hold period in order to avoid the punishing consequences of rolling positions in a negative-roll yield environment over several months.

Investors use a 2x leveraged Bull or Bear to magnify the returns anticipated in the underlying commodity. For hold periods greater than a day, any day the underlying moves in the opposite direction to that desired, the holder is leveraged to being wrong.

By mid-2009, given the noted conditions, investors had long forgotten that being exposed to rising crude prices in H1, 2008 had been hugely profitable, and 2x leverage worked well even over multiple-day hold periods.

Natural gas

Natural gas prices rise in the traditional high-demand winter period. This is perhaps best captured in the table below, which provides both prices and month-over-month percentage price changes in the then-quoted natural gas futures prices. The key takeaway: in December 2009, natural gas traded at a 17% premium relative to November 2009, and January 2010 at a further 5.1% premium to December.

Effectively, these anticipated price gains in the futures market become your required return thresholds before making money—if you stayed long through several contract rolls via an ETF (such as UNG in the US, or GAS and leveraged HNU in Canada).

	09/15/2011	09/30/2010	09/30/2009	09/15/2011	09/30/2010	9/30/2009
1 month	3.921
2 month	4.011	3.872	4.841
3 month	4.22	4.122	5.674	5.2%	6.5%	17.2%
4 month	4.342	4.294	5.965	2.9%	4.2%	5.1%
5 month	4.362	4.313	5.991	0.5%	0.4%	0.4%
6 month	4.334	4.259	5.937	-0.6%	-1.3%	-0.9%

You can see a different context in terms of future prices for natural gas, both for the winter months of 2010, and for those ahead this year, with much more subdued price gains being anticipated, significantly reducing the required return thresholds.

Yves Rebetez, CFA, is an ETF specialist and managing director of ETFinsight. Sources for underlying prices: Bloomberg and Horizons ETFs, respectively; US EIA and Kitco.

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