Volatility draws billions into oil funds

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London/new York | March 07, 2015 12:02 AM

Assets of top oil funds quadruple to $5.4 bn since July, Contango structure trims gains through roll costs

Billions of dollars are pouring into oil exchange-traded funds as investors, many of them small savers more familiar with stocks than commodities, risk big losses and focus on the chance of huge rewards.

Five of the biggest oil ETFs have seen their assets more than quadruple since July to $5.4 billion as the oil market has had a roller-coaster ride, collapsing by 60 percent then rallying by almost a third.

ETFs, designed for investors who cannot or will not buy and sell oil directly themselves, offer easy access and exposure to oil volatility because they are based on traded futures markets.

Many small investors such as pensioners, hobby traders, and savers on fixed incomes are attracted to oil ETFs, which can be designed to take advantage of price rises or falls.

But the volatility and structure of the underlying markets also make such investments dangerous for unwary investors.

“They can be quite dodgy,” said a British woman who buys and sells oil derivatives from a rambling country house in western England using a trading platform run from a tax haven in the Caribbean.

“The smallest market difference can make you a lot of money – or a massive loss,” she said, asking not to be identified.

One of the biggest risks for investors, particularly if they have “long-only” funds that buy and sell the front-end of futures, is the price structure of the underlying market.

If oil is rising in price and in short supply, futures markets may trade in “backwardation”, with the front futures months at a premium to later months. When the front-month contract expires every four weeks, funds buy the second month and pocket the difference, earning a healthy profit.

But when futures markets have the opposite structure, a “contango” with the front months discounted to subsequent months, the process is reversed with funds having to pay out every month to buy the more expensive next months.

Both of the world’s top crude oil benchmarks, North Sea Brent and U.S light crude, have been in contango for months, limiting any gains.
Oil funds are particularly attractive to many investors because they offer high gearing at a time when interest rates and fixed-income bond yields are at record lows.

One fund, VelocityShares 3X Long Crude ETN, has seen its net assets rocket to $698.4 million at the end of February from $1.6 million at the end of July last year.

The fund is leveraged three times and produces even bigger daily swings than the moves of up to 5 percent that the market has come to expect since prices hit six-year lows in January.

Carsten Fritsch, senior oil and commodities analyst at Commerzbank, says investors have flooded into oil derivatives over the last few months, helping to support prices. “It was money flowing into oil ETPs (exchange-traded products) with stocks at record highs and bond yields at record lows,” he told Reuters Global Oil Forum, an online chatroom for oil market professionals.

Oil funds are also seeing interest from computer-driven algorithmic and high-frequency trading.

That may be contributing to volatility in oil prices, especially the US crude benchmark that most oil ETFs seek to track. Since January, the Oil Volatility Index has risen to highs not seen since 2011, the year of the Arab Spring.

“Investors have focused very specifically on oil and gold, using exchange-traded products to get opportunistic exposure to the two markets which have been particularly volatile recently,” Barclays analyst Suki Cooper said in a note to clients.

Many savers invest in ETFs and ETPs via hedge funds, letting professional traders handle their exposure and risk.

John Hyland, manager of the United States Oil fund, one of the largest ETFs, said a large part of his investor base was ETF hedge funds: “If we could go to all the broker dealers and say ‘hand me the list of investors’, 80 to 90 percent of our shares would probably be held by investors whose physical address is Connecticut, whose legal domicile is the Cayman Islands, and who have a Greek or Roman god in the name of the company.”

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