U.S. Oil Investment: Things you should know… in advance
by Patrick Oberhaensli, on Aug 31, 2020 3:49:00 PM
For institutional investors, getting exposure to U.S. oil typically takes place through the use of futures, either directly (also in mandates) or, more commonly, indirectly through funds (exchange traded or not) or structured products. Trading houses, contrary to institutional investors, gain exposure via a physical investment, applying more or less complex active strategies, as well as involving derivatives.
As it is one of the most fascinating trading instruments for investors, we have dedicated this article to analyzing the main characteristics of a simple and classic U.S. oil investment, in particular its risks aspects.
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U.S. oil long-only passive: a lackluster investment (longer-term)
As a first step, it is worth having a closer look at the U.S. oil long-only passive investment implemented with futures which need to be rolled when approaching expiration. This technique has an impact related to convenience yield (the advantage to own the asset now).
For the period starting end of January 2007 up to the 27th of May 2020, including specific costs, we see the following for the long-only passive U.S. oil investment:
With an average annual loss of 18.90% over the considered long-term period, U.S. oil is clearly a very unattractive investment. Of course, this result is dependent on the period shown, but when assessing a strategy it's important to consider the total possible loss if one invests at the worst point in time. An almost total loss must be concretely envisaged as the maximum drawdown indicates. As the “best months” in the table above indicate, investing at the most opportune moment can lead to a strong performance: this is quite common of markets that are very/extremely volatile.
Talking about volatility, in this case historical volatility, it is at about 38% which is sharply higher that of U.S. equities (U.S. Large Cap at about 15% long term volatility for 20+ years and U.S. Mid Cap at about 17-18% long-term volatility for 19+ years). Due to the (deeply) negative returns, the Sharpe Ratio is mechanically negative while the percentage of positive monthly returns is below the 50%.
The volatility also makes it difficult to consider a short-only passive approach. Even though being short would have allowed to benefit from the exceptional occurrence of a negative futures price – this is only possible if the position had been held on the day before expiration day. However, this is quite unlikely considering futures are typically rolled over several days before expiration! The historic event on Monday 20th of April 2020 where May 2020 futures settled at -37.63 USD. a barrel on, the day before contract expiration, has only happened once in history, so far...
Typically, long-term correlations with other asset classes also provide useful insights. We will elaborate in the following section.
The Potential of a More Sophisticated Strategy
The long-term correlation with U.S. equities is around the 0.4 level (period of 22+ years ending in January 2020) and at about -0.3 with U.S. government bonds with very long duration. The latter is not a surprise, given that government bonds were and still are in a rally mode and oil is losing a lot on the long run. Such a low/negative correlation constellation combined with the very high volatility of U.S. oil often leads to opportunities when considering strategies that are very flexible. This is especially true if the fluctuations in these correlations don’t happen in an abrupt way.
In addition to government bonds and U.S. equities, the correlation within the commodities segment can also be helpful if very low or even negative. For example, this is the case for oil and gold with a correlation of only 0.2. In other words, investors should consider mixing the two assets via an active approach.
U.S. oil, like other energy products such as natural gas, is a very risky investment when considering the passive long-only approach. This is related to the use of futures as a practical mean of gaining exposure (rolling). Despite the possible quasi-total-loss when applying a Buy-and-Hold, an alternative active portfolio management technique is likely to offer an adapted (attractive) risk-return profile. We will explore the well improved risk-adjusted return in the second part article dedicated to U.S. oil investing.
EVOLIDS FINANCE LLC, Disclaimer:
- This content is not intended to be a solicitation nor an offer
- The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible