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Crude oil is a commodity with an investment value, apart from being an essential energy resource. You may wonder how retail investors can invest in crude oil. Unlike an oil company, you can’t buy and stock up barrels of crude oil.

Crude oil futures exchange-traded fund (ETF) provides a way for retail investors to invest in this kind of commodity, instead of investing directly in crude oil. It aims to track the performance of a specified crude oil futures index, ie the underlying index, by primarily investing in crude oil futures contracts.

Crude oil futures ETF is new to Hong Kong. You should know how it works and the risks involved before making an investment decision. The following pointers help you understand more about this type of products.

What is the ETF tracking?

Many varieties of crude oil are produced around the world, each traded at its own price. Due to the wide variety, crude oils are priced and traded relative to well-known benchmarks. The two most well-known benchmark types of crude oil are the West Texas Intermediate (“WTI”) and the Brent Blend ("Brent"). The WTI is the major benchmark for the crude oil in the Americas and the Brent is the primary benchmark for the crude oil in Europe or Africa.

Different crude oil futures contracts are traded on various exchanges including the New York Mercantile Exchange, Inc. (“NYMEX”), Intercontinental Exchange, Inc. (“ICE”) and the Dubai Mercantile Exchange Limited. The WTI crude oil futures contracts and the Brent crude oil futures contracts, which are traded on the NYMEX and the ICE Futures Market in London respectively, are the two most liquid crude oil futures contracts.

A crude oil futures ETF aims to track the performance of an underlying index comprising specific crude oil futures contracts such as the WTI and Brent crude oil futures contracts.

How does a crude oil futures ETF work?

A crude oil futures ETF aims to replicate the performance of an underlying crude oil futures index by investing in the corresponding crude oil futures contracts. Depending on the index methodology and the ETF’s investment strategy, it can invest in futures contracts with short-term or long-term (eg 12 months) maturities or a mixture of different maturities.

You should note that the performance of the underlying crude oil futures index and the crude oil futures ETF can significantly deviate from the spot price of the crude oil because the underlying index is based on the price of the crude oil futures contracts and not on the price of physical crude oil. The prices of crude oil futures contracts may not always go in line with the price of crude oil in the spot markets. For further details, please refer to the section "Risk of rolling futures contracts" below.

For illustrative purpose, the chart below shows the change in spot price of physical WTI against the return from investing in WTI futures contracts (note) in 2009. During the period, the spot price increased by approximately 71% while the return of the WTI futures contracts was approximately 3%.

What are the risks of investing in the crude oil futures ETF?

There are a number of risks associated with ETFs that are also applicable to crude oil futures ETFs. You may refer to the "ETF-major risks" (see recommended reading below) to learn more about the major risks of ETF.

Crude oil futures ETFs also have the same characteristics and risk profile as a futures-based ETF. One key risk is that of rolling futures contracts.

Risk of rolling futures contracts:

A crude oil futures contract is a commitment to buy or sell a predefined amount of the underlying crude oil at a predetermined price on a specified future date with the contract settled in cash. "Rollover" means selling existing futures contracts that are about to expire and replacing them with futures contracts that will expire at a later date (ie longer-term contracts). If the prices of the longer-term contracts are higher than those of the expiring contracts, the proceeds from selling the expiring contracts will not be sufficient to buy the same number of longer-term contracts. Given that a futures-based ETF needs to rollover the futures contracts for the purpose of replicating the underlying futures index, a loss may incur (ie a negative roll yield) and would adversely affect the net asset value of the ETF.

There is a variety of crude oil futures indices which could be different in multiple respects, and most notably, in their rolling strategies. The strategy would affect how closely the index correlates to the price of crude oil in the spot markets, and the roll yield and the net asset value of the crude oil futures ETFs. Investors should carefully study the crude oil futures index used by the ETF. For more details about the nature and major risks of a futures-based commodity ETF, you may refer to the "Futures-based ETF" and "Commodities funds" (see recommended reading below).

What should you do before making an investment decision?

You should first read the product key facts statement and the offering document to fully understand the nature, investment objective and strategy, the underlying index, fees and charges, features and major risks of a crude oil futures ETF.

You should then consider carefully whether the product suits your investment objective, the amount of investment required and your risk capability. If you have any questions, do ask your intermediaries to make sure that the product is really suitable for you before making an investment decision.

You may find out the definition of some terminologies used in this article in the "Glossary" section.

 

(Note): The return of the WTI futures contracts is calculated based on (i) changes in the price of the nearest WTI futures contracts; and (ii) the gain and loss resulting from the rolling of the nearest contracts to the next nearest contracts as the nearest contracts approach maturity.