On a year-to-date basis, the iPath Pure Beta Crude Oil ETN (OLEM) has taken a bit of a beating with shares falling by around 15%. In this piece, I will argue that not only are crude fundamentals suggestive of higher prices, but also OLEM’s instrument-specific methodology is currently shining in that based on the structure of WTI futures, it is empowered to deliver on its primary mandate.
Before jumping into an analysis of the crude markets, let’s start by looking under the hood at exactly what OLEM is and what it does. Put simply, OLEM is an instrument designed to address a very real problem in the oil ETP space: roll yield.
To understand the crux of the problem, we need to look no further than the historical returns of the ever-so-popular USO ETF versus the underlying price of crude oil.
As you can see in the chart above, USO has a history of underperforming versus the price of WTI in most years. The reason why this is the case is something called roll yield – this source of return is a drag on many ETPs in the commodity territory, and it’s the problem that OLEM attempts to directly fix.
So, what is roll yield? Put simply, roll yield is what happens when you’re holding exposure across a futures curve and while “futures converge towards spot”. There’s a general tendency in financial markets for futures prices to move towards the spot price of the market as time progresses. This means that the direction and magnitude of roll yield is a direct result of the structure of futures curves. As you can see in the chart below, WTI futures have been in contango in the front of the curve for much of the past few years.
What this tangibly means is that for most ETPs which follow the popular commodity indices like BCOM or GSCI, roll yield has largely been negative, since exposure is strictly limited to these front two months in many of these indices. The reason why roll yield has largely been negative is that since the market has generally been in contango, long exposure is rolled into higher-priced contracts than the front-month contract, and as time progresses, these prices tend to decline in value towards the spot price on a relative basis. This is the driving force behind the previous chart showing USO’s underperformance: futures converge towards spot, and when the futures are priced higher than spot, this means they’ll generally decline in value on a relative basis. And this is where OLEM’s methodology enters the scene.
As part of iPath’s “Pure Beta” family, OLEM actively manages which month is held so as to minimize roll yield. What this practically means is that since futures converge towards spot, the general goal of the ETN will be to hold a futures contract which is most closely priced to spot, so that the roll towards spot will have the smallest footprint possible.
Unfortunately, this state rarely happens in that the market is generally always in either contango or backwardation across the curve, but the present futures curve offers OLEM the ability to essentially roll exposure into contracts which are closely priced towards spot.
The inflection in the futures curve means that if OLEM decides to hold exposure later in the back quarter of the year, it will be able to potentially greatly reduce roll yield so that the underlying return of the ETN more closely tracks crude oil. This tangibly means that in this current market environment, OLEM is able to deliver on its mandate, and investors looking for the closest tracking of WTI futures should consider holding the ETN at this time.
While it is important to note that OLEM is able to deliver on its mandate and provide an almost roll yield free return at this specific moment, we can also benefit by looking at crude markets in general to get an idea of where they are likely headed in the near future.
Simply put, I am quite bullish crude oil, based on the fundamentals which continue to tighten. Specifically, on a year-over-year basis, we continue to see inventories decline.
The reason why this specific relationship is important to monitor is that it concisely shows which side of the supply and demand balance is being overwhelmed by the other. At this juncture, supply is unable to keep up with demand, which means that inventories are declining.
We’re running a little long to do a full deep dive here, so I’ll keep it brief. The reason why stocks are declining has to do with two supply-side fundamentals. First off, production growth is slowing.
This decline in production is evidenced by broad-based slowing growth rates, as well as declining rig counts.
And secondly, OPEC cuts remain in place, which is causing several multi-year lows in crude imports into the United States.
The common factor pulling these two elements together is this: there are powerful forces at work beneath the scenes that require higher prices for supply to once again resume. On the production side, a wave of bankruptcies is being fueled by capital constraints imposed by banks. These restraints will be relaxed when cash flows improve, and the fastest way to improve cash flows in this business is to increase revenues which come directly through higher prices. And on OPEC’s side, it has a clear history of acting when prices are lower, and OPEC has a meeting within a month at which it is likely to roll the production cuts in place forward to provide stimulus to the market.
Based on these twin variables of supply, I believe the trend in declining inventories will continue until prices increase. For those looking to trade oil, OLEM makes for an attractive play at this time, based on its ability to provide a return largely stripped of roll yield as well as crude fundamentals which continue to tighten.
OLEM has a unique methodology which the market is currently rewarding through an inflection in the term structure of WTI futures. Crude fundamentals are tightening based on two key supply risks to the market – and this tightness is likely to continue until prices rise. Based on OLEM’s methodology as well as tightening fundamentals, it’s a great time to buy the ETN.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.