Starting in late February 2022, oil and gas markets surged to near all-time highs in response to potential supply issues and the geopolitical impacts of the Russian invasion of Ukraine. In response, many investors may be trying to capture the momentum and swings by trading crude oil futures, or at least investing in crude oil futures ETFs.
Oil prices have been volatile during this period with WTI Crude oil futures hitting a high of more than $120 U.S. on March 8, 2022, but subsequently declining to around $100 a week later.1
Trading commodity derivatives can be complex and leave investors exposed to substantial risk, but investing in commodity-producing companies may not be the most efficient way to gain exposure to an underlying commodity. Instead, many traders use ETFs to access particular commodities through a simpler, managed trading vehicle.
When investing in oil and gas ETFs, it’s crucial to understand that there are potentially less volatile ways to access the market, which over time, could lead to a better return profile than more common strategies, such as oil producer equities and short-term futures.
HUC & USO: Winter-Month Contracts Versus Front-Month Contracts
In the charts below, we’ve highlighted the performance and drawdowns of the Horizons Crude Oil ETF (HUC) versus the United States Oil ETF (USO), to contrast the difference between investing in Winter Month contracts via HUC and Front-Month contracts through USO. We’ve also highlighted the performance and drawdowns of the pipeline-focused Horizons Pipelines & Energy Services Index ETF (HOG) versus producer-focused S&P/TSX Capped Energy Index to show investors ways to reduce their expected risk by using our ETFs to gain exposure to the energy sector.
Source: Morningstar Direct as at February 28th, 2022
The Winter Month contract that HUC tracks is historically quite liquid, but generally less volatile than the shorted-dated oil futures contracts used by USO; most of this can be explained using simple math. The important thing in understanding oil futures is that they are priced in dollars, so looking at roll yields and the difference in contract prices in percentage terms can create some confusion. This is an asset class you want to think of in terms of nominal dollars.
Typically, the reason longer-dated contracts are more expensive is because there are a multitude of additional costs that get priced into them, including storage, and similar to options, a certain amount of time-decay. If you hold a longer-dated derivative, which a futures contract is, there is a higher likelihood of it increasing in value over the lifetime of that contract. Similar to options and puts, longer-dated contracts are more expensive to compensate for the risk of the seller losing money on the trade. Currently, the crude oil futures market is in massive backwardation, meaning the longer-dated contracts are cheaper than the shorter-dated contracts.
What is Backwardation?
Backwardation is the inverse condition of contango, in which the price of a futures contract is trading below the expected spot price at contract maturity, and the futures curve is downward sloping. In a backwardation environment, an investor who is in long futures may experience positive “roll yield” if the contract is rolled after the futures price rises to converge with the expected spot price (assuming an unchanged spot price at maturity). Even if the commodity declines, as predicted by the futures curve at the time of the investment, the investor holding long futures may experience no loss. Typically, investors would therefore want to be long futures if the futures curve is in backwardation, unless they expect the commodity to decline by more than what is priced into the futures curve.
Let’s look at the current difference between the April 2022 Crude Oil Contract and the December 2022 Crude Oil contract.
As at March 17, 2022, the April 2022 contract was valued at approximately $102.37, where the December 2022 contract was valued at roughly $87.53. This is a rare occurrence of backwardation where the front month contract is priced higher than the December contract. This means investors are actually making money on roll yields, but it also highlights that the market is pricing in a steep decline in oil prices for the latter half of the year.
Historically, the Winter Month contract works for longer holding periods simply because it loses less on downswings and therefore has potentially more capital to compound on an upswing in oil prices. Over shorter periods, we would anticipate that the Winter Month contract would typically underperform shorter-dated contracts during a shorter-term spike in oil prices.
It should be noted that the Winter Month contract is not going to directly reflect 1:1 increase/decrease in dollar value versus the price of oil. However, it should reflect changes, although less significant relative to the price of oil, over shorter periods.
To To understand how the June roll may impact HUC’s performance, let’s take a look at the Solactive Light Sweet Crude Oil Winter MD Rolling Futures Index, the index that HUC seeks to replicate, which rolls its contract exposure to the next calendar year during mid-June. The exact roll methodology for this is as follows:
| Business Day in June | 1st-9th | 10th | 11th | 12th | 13th | 14th | 15th | 16th | 17th |
| Primary Contract | 100% | 87.5% | 75% | 62.5% | 50% | 37.5% | 25% | 12.5% | 0% |
| Secondary Contract | 0% | 12.5% | 25% | 37.5% | 50% | 62.5% | 75% | 87.5% | 100% |
Source: Horizons ETFs and Solactive AG
HOG & The S&P/TSX Capped Energy Index: Pipelines Versus Producers
For investors looking for a more risk-averse way to get exposure to Canada’s energy sector, from a long term perspective, arguably one of the best ETF strategies to gain exposure to this sector is through the Horizons Pipelines and Energy Services Index ETF (HOG).
The big difference between HOG, which seeks to replicate, to the extent possible, the performance of the Solactive Pipelines & Energy Services Index, versus a broad energy equity index such as the S&P/TSX Capped Energy Index – which we also offer exposure to through Horizons S&P/TSX Capped Energy Index ETF (HXE) – is that it has less direct exposure to the price of oil versus the broad energy index. Typically, both small and large energy production companies such as Suncor, Cenovus or Canadian Natural Resources have a lot of direct exposure to energy prices for obvious reasons. Historically, these companies, particularly the Canadian producers who extract the heavier Canadian crude oil, have a high degree of correlation to oil prices, since the Western Canadian Select crude they extract is typically heavier and more expensive to process.
Pipelines are bit more resistant to the swings in oil volatility and this has a lot to do with their functionality in the oil and gas supply chain. Energy producers need to transport oil and gas, so they typically pay locked-in prices to transport the energy. This means, regardless of energy prices, at any time, oil and natural gas are flowing through pipelines to refineries. Typically, an energy producer will get a lot more “leverage” on its balance sheet if oil prices increase and they are extracting oil, as that commodity now increases revenue but it also helps the bottom line of pipeline companies, which would tend to see a surge in activity during rising energy prices and can charge a premium to transport any excess capacity that might remain in their distribution network.
You can see this is in the performance characteristics of HOG vs. HXE, where HOG has a positive return since its inception in July 2014 of 3.60%, vs a return of -2.84% for HXE over the same period2. Add in a current estimated annualized yield of 3.45% as at December 31, 20213. and this becomes a lower-volatility way to capture most of the upside of energy moves, with potentially higher income and lower drawdowns than the broader energy sector. Please see the standard performance data below.
Investment Objectives
HUC: HUC seeks investment results, before fees, expenses, distributions, brokerage commissions and other transaction costs, that endeavour to correspond to the performance of the Solactive Light Sweet Crude Oil Winter MD Rolling Futures Index ER. HUC is denominated in Canadian dollars. Any U.S. dollar gains or losses as a result of the ETF’s investment will be hedged back to the Canadian dollar to the best of the ETF’s ability.
USO: USO’s investment objective is for the daily changes, in percentage terms, of its shares’ NAV to reflect the daily changes, in percentage terms, of the spot price of light sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in the Benchmark Futures Contract. Specifically, USO seeks for the average daily percentage change in USO’s net asset value, for any period of 30 successive valuation days, to be within plus/minus 10% of the average daily percentage change in the price of the Benchmark Oil Futures Contract over the same period.
HOG: HOG seeks to replicate, to the extent possible, the performance of the Solactive Pipelines & Energy Services Index, net of expenses. The Solactive Pipelines & Energy Services Index is designed to provide exposure to equity securities of certain Canadian oil and gas companies in the Midstream Sector.
HXE: HXE seeks to replicate, to the extent possible, the performance of the S&P/TSX Capped Energy Index (Total Return), net of expenses. The S&P/TSX Capped Energy Index (Total Return) is designed to measure the performance of Canadian energy sector equity securities included in the S&P/TSX Composite Index. The relative weight of any single index constituent security is capped.
Standard Performance Chart: Source Morningstar as at February 28, 2022.
Common Inception: July 14, 2014 until February 28, 2022
1https://www.barrons.com/market-data/futures/cl.1?mod=md_cmd_overview_quote
2Period from July 14, 2014 until February 28, 2022
3An estimate of the annualized yield an investor would receive is the most recent distribution rate stayed the same for the next twelve months, stated as a percentage of the net asset value per unit on the date before the ex-dividend date of the current distribution.
Commissions, management fees and expenses all may be associated with an investment in exchange traded products (the “Horizons Exchange Traded Products”) managed by Horizons ETFs Management (Canada) Inc. The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.
The indicated ETF rates of return are the historical annual compounded total returns, including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Additionally, index returns do not take into account management, operating or trading expenses that may be incurred in replicating the index. The rates of return above are not indicative of future returns. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. The indices are not directly investible. Only the returns for periods of one year or greater are annualized returns.
Certain statements may constitute a forward-looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.
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