The oil market has been a hot topic in recent months, with prices surging due to supply disruptions and geopolitical tensions. However, the real story lies not in the price of oil itself, but in the performance of oil futures exchange-traded funds (ETFs). The United States Oil Fund (USO), in particular, has seen a staggering 105.5% gain since the start of the year, nearly double the 59% gain in front-month crude futures.
What's Behind the Strong Performance of Oil ETFs?
The key to understanding the outperformance of oil ETFs lies in the shape of the futures curve. The futures curve is a graphical representation of the prices of oil futures contracts at different expiration dates. When the next month's contract trades higher than the current one, the market is said to be in contango. Conversely, when the next month's contract trades lower than the current one, the market is in backwardation. The shape of the curve has a significant impact on the performance of oil ETFs, as they roll into the following month's contracts as the current ones expire.
Steep Backwardation: A Boon for Oil ETFs
Since the Iran war began on February 28, the oil market has been in steep backwardation. Traders sharply bid up near-month contracts on the supply disruption in the Strait of Hormuz, while later-month contracts rose far less, on the assumption that the disruption would prove temporary and supplies would normalize. However, the normalization of supplies has been much slower to arrive than expected, with the strait remaining obstructed and attacks on tankers continuing. As a result, oil prices have stayed higher than the futures market initially priced in, and the curve has stayed backwardated.
The Impact of Roll Yield on Oil ETFs
The steep backwardation has resulted in a significant "roll yield" for oil ETFs. When USO rolls into the next month's contracts, it can sell the current month's contracts and buy about 3.4% more of the next month's contracts, adding to its returns as long as oil holds around $91.30 or higher. This type of roll yield is the reason for the wide gap between the return on oil and the return on the fund. The effect is even more striking measured from oil's peak, with WTI closing near $113 on April 7 and falling more than 19% since then, yet USO is up about 3%.
Unusual Situation for Holders of Oil ETFs
It's an unusual situation for holders of these funds. Oil prices have been flat to lower since their wartime peaks, yet because of the steep backwardation, returns have continued to accumulate. This is a stark contrast to the typical behavior of oil ETFs, which tend to track the price of oil closely. The steep backwardation has created a unique opportunity for investors to benefit from the roll yield, even as oil prices have remained relatively stable.
What to Watch Next
As the situation in the Strait of Hormuz continues to unfold, investors will be watching closely to see how the oil market responds. If the normalization of supplies accelerates, the steep backwardation may begin to unwind, and the roll yield may decrease. Conversely, if the supply disruptions persist, the backwardation may continue, and the roll yield may remain a key driver of returns for oil ETFs. Investors will need to keep a close eye on the futures curve and the performance of oil ETFs to navigate this complex and rapidly evolving market.
