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On a year-to-date basis, shareholders of the iPath Pure Beta Crude Oil ETN (OLEM) have been rewarded with a price appreciation of nearly 19%. While these returns have been strong, I believe that going forward we will see additional upside in the ETN due both to its methodology as well as the underlying fundamentals of crude oil.
Understanding OLEM
Let’s start this article off with a discussion of what exactly the iPath Pure Beta Crude Oil ETN actually is. There are numerous ETPs which give exposure to oil markets and a myriad of approaches for handling futures exposure. The basic idea behind OLEM is that it seeks to give exposure to the Barclays WTI Oil Pure Beta TR Index. This index gives unleveraged exposure to WTI futures and it does so in a way which seeks to minimize roll yield.
If you’re unfamiliar with roll yield, this paragraph is for you. Put simply, roll yield is the gain or loss that arises from holding exposure through time across a futures curve. Roll yield arises due to the tendency of financial markets for prices in the back of the curve to trade towards the front of the curve as time progresses. As you can imagine, the effects of roll yield are highly dependent on the structure of the market at the time. For example, when a market is in contango (front contract priced lower than back month contracts), roll yield will be negative for long traders because the contracts held at higher prices will tend to trade down in price as time progresses as they roll towards the front. Conversely, when a market is in backwardation (front contract trading above the back-month futures contracts), roll yield will be positive because the futures contracts held at lower prices will trade up in value as time progresses.
The minimization of this tendency from holding futures exposure is what OLEM seeks to accomplish and it does so through dynamically shifting exposure so that it can minimize roll. How this works is that the strategy will look to find the futures contract most closely priced to today’s front-month contract, and when it comes time to roll, it will sell out of exposure in the currently-held month and roll into the exposure of the next similarly priced contract.
Note that this strategy is doubled-edged in that it minimizes the impacts of both the positive and the negative roll effects through time. For example, the WTI futures market has been in backwardation as of late, but long-run statistics will show that over the last decade, the front two contracts have traded in contango in about 78% of all months. This means that over the last decade, an investment simply rolling in the front two months would have seen substantial losses from roll yield. However, the WTI futures market is currently in backwardation across the front year of the forward curve which means that OLEM is actively seeking to reduce a source of positive yield. This is a good thing if the return you want to earn is as close as possible to the price per barrel of crude oil through time, but on an absolute return basis, OLEM is currently under-delivering versus other comparable ETPs with roll-naïve (USO) or roll-maximizing approaches (DBO). This said, let’s examine the crude market fundamentals to understand where the larger trend of OLEM’s shares is likely headed.
Crude Fundamentals
Put simply, the state of crude oil supply and demand balance is bullish. As I argued this weekend, the underlying fundamental situation is that we are currently seeing the impacts of weak demand being dwarfed by the constrained supply situation in the United States. This is currently dragging down the level of inventories to fall beneath the 5-year average.
The reason why this trend is occurring is almost entirely due to the fact that OPEC cuts have reduced a substantial amount of imports coming into the United States with most weeks of this year coming in below the 5-year range in one of the lowest outright level of imports seen in decades.
OPEC has clearly communicated that these cuts will remain in place through March of 2020 which means that even if refining demand doesn’t improve, inventories are largely going to continue underperforming the seasonal trends in stocks.
The reason why this matters to crude oil bulls and bears is that there is a direct correlation between what happens in crude inventories versus what happens to the price of crude oil. Specifically, here is a chart that takes a 2-month trend in crude stocks and compares it to the 2-month trend in the 5-year average of crude stocks. I have simplified this metric to make it show a red bar if crude inventories are building versus the 5-year average trend or green if stocks are drawing. As you can see, this metric is currently bullish the price of crude and has a history of calling every major trend in crude in recent years.
This method of analysis is not a Holy Grail (and indeed, it can have delayed responses to price), but it gives us a general quantified relationship that can steer our investments in the crude markets. At present, crude inventories are falling versus the 5-year average due to the fact that OPEC is remaining unwavering in its cuts. This relationship will continue for at least 5-6 more months which means that we are likely to see additional tightness against the 5-year trend in inventories. While this happens, prices tend to rise which means that we should see higher prices in crude oil in the future.
OLEM is poised to capture this increase in crude pricing since it seeks to give direct exposure to the price changes in crude oil. The potential downside to choosing OLEM as your investment vehicle to capture the uptrend is that you will be minimizing roll yield in a backwardated market which means you’ll leave some return on the table compared to more roll-maximizing strategies like DBO. However, if you are looking for the pure oil trade, OLEM makes for a great long trade at this time.
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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