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If you are an investor in ProShares K‑1 Free Crude Oil Strategy ETF (OILK), then you probably know exactly why you are holding it. OILK is a very unique ETF in the commodity space in that it essentially seeks to provide a more attractive alternative to the more popular oil ETFs (USO). The strength of OILK comes from its two key value-adds versus other WTI-exposed commodities: K-1 free reporting and an actively managed roll-mitigation strategy. In this article, I will dig into these two value-adds to evaluate the strategy of the instrument and then take a look at the fundamentals of the oil industry to make an overall recommendation on the ETF. If you’re pressed for time, I’ll leave you with my conclusion: even if you actively manage roll in WTI futures, the crude markets are structurally and fundamentally bearish right now, and you should avoid OILK.
The first key benefit of OILK is that it provides a K-1 free investment. If you’re invested in OILK, then you know exactly what this form is and why it’s easier for your taxes to not need one. For the purposes of this article, I am assuming that if you are investing in OILK, you are familiar with this tax advantage (as well as how ProShares invests through its Cayman Island subsidiary), and you have chosen it specifically for this reason.
The next benefit of OILK is that it offers an active management of the rolling process of WTI futures. And, this is where things get muddy.
The basic problem when you invest in commodity markets in the form of an instrument which doesn’t expire (like at stock) is that you have to roll your exposure as futures contracts near expiration. When you roll your position, you are tangibly selling out of one position and entering a position in a later month. Futures markets have a funny tendency, and that is that, in general, contracts further out on the curve converge towards the front month contract as the month progresses. This tangibly means that if you are holding positions spread across a few different months, you will experience something called “roll yield” as your back position gradually closes the distance to the front position. When the front contract is below the back contract (known as contango), then roll yield will probably be negative as your position in later months decreases in value on a relative basis versus the front months. When the market is in backwardation (front over back), you will likely see gains from positive roll yield as positions in the back gain versus prompt.
OILK employs a very interesting method for handling roll: they actively manage it. If you read through the prospectus, you will see that ProShares uses a strategy that shifts exposure between the front three contracts based on their assessment and internal methodology. This strategy is not divulged in its prospectus (and is likely considered to be their “secret sauce”), so we are forced to simply evaluate its effectiveness.
In the prospectus, it states that “The Fund’s strategy seeks to outperform certain index based strategies by actively managing the rolling of WTI crude oil futures contracts“. I read this as code for “We try to do a better job than USO at managing the roll.” USO is by far the most popular oil ETF, and roll yield in that instrument is notorious. If OILK can provide an alternative strategy that outperforms USO’s roll yield problems, then it can deliver a substantial value proposition for equity investors seeking exposure to the crude oil markets.
In the chart below, I have compared USO, OILK, and the return of the front month WTI contract from the beginning of 2018 until now. I have chosen this period specifically because the market has shifted from backwardation to contango during this window. If there ever was a time for OILK to shine, this was it. So, how did it do?
The first thing to note for both ETFs is that they have each over-performed versus the flat price of WTI. This is to be expected in a backwardated environment due to positive roll yield. However, it appears that versus USO, OILK has slightly underperformed. Here’s a view of the relative difference between USO and OILK with an overlay of the market structure of WTI front-month futures given.
As you can see in the chart above, OILK has actually underperformed USO by about 3% over the last year. In fact, the underperformance began in earnest during the period in which front-month backwardation widened the most around July of last year.
The reason for this underperformance is quite simple. During last summer, Cushing specific factors led to rapid backwardation and the front contracts blowing out versus the back. For example, the cash-to-prompt spread blew out to $2/bbl on a weekly basis as seen in the following chart.
When the market has physical constraints, OILK will underperform USO in all likelihood simply because OILK’s roll exposure will dampen the effects of massive front-month backwardation due to its holding positions out to third month. USO follows a much simpler methodology of rolling across two months in a certain window, so it will capture these blowouts better.
Despite OILK’s claims to give a better exposure to roll through active management, I’m afraid the proof simply isn’t in the pudding. Even neglecting the Cushing constraints which gave massive headwind to USO for having closer-to-prompt exposure, OILK has largely either matched or underperformed USO in most weeks. So, if you’re holding OILK for the reason of active roll management, this isn’t really an attractive feature adding to returns at this stage in its life. In fact, one could argue that OILK’s active management shoots itself in the foot in regards to roll yield in that during backwardation and extreme supply constraints, positions concentrated at the front of the curve will reap massive roll yield benefits, while back positions will not experience nearly as much good. In other words, active management that shifts exposure back on the curve is exactly the wrong thing to do during periods of extremely positive roll yield.
All of this is simply mechanics of the ETF and evaluating its two core allures for investors. But let’s take a step back. We are quibbling over 1-3% differentials in performance on an instrument which has moved within a 70% range over the last year. As investors, we should not ignore these differentials – but we should seek to understand these larger shifts in volatility and what’s driving them. We should study the fundamentals of the crude markets.
Time doesn’t permit me to exhaustively study the fundamentals in this piece (I’d recommend this article for that). However, we can definitively say a few key things about the North American crude markets. The first of which is that they are pretty strongly oversupplied.
As seen in the chart above, crude inventories have traded above their 5-year average all of this year, and it appears to be holding ground in the territory of oversupply. OILK tracks WTI which settles at Cushing and the inventories at Cushing are telling a pretty interesting story.
Despite starting the year with supply a bit constrained at Cushing, we have seen inventories surge back to its 5-year average in a move which has decisively shifted the market once again into balance. This balance seen here as well as the overall oversupply seen in North America has led to a market consistently caught in contango with inventories remaining above its 5-year average.
A direct correlation exists between the trajectory of inventories and price movements of WTI as you can see in the following chart. As go inventories, so go prices.
Given the oversupplied state of oil in the United States, we are likely to continue to see lower prices. Until we are able to get inventories back below its 5-year average, then the fundamental picture remains bearish. The market is currently trying to balance through higher exports:
As well as through higher refining runs:
However, the presence of elevated product stocks in gasoline has crushed the refining margin as seen in the following charts.
Until this gasoline glut is cleared, we will continue to be in a bearish fundamental environment which makes an investment in OILK questionable. I believe that investors in OILK should consider not touching the ETF until gasoline inventories begin to clear and refining crack improve. I believe that the point this will begin is in May when summer driving season begins and that at least until then, investments in OILK are trading against the fundamental outlook.
Despite the tax benefits of OILK, both the roll strategy and fundamental outlook do not favor a trade at this time. I’d suggest shorting or avoiding it for the time being.
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.
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