Home Trading ETFs USL: A Huge Play On Crude Market Structure – The United States 12 Month Oil ETF, LP (NYSEARCA:USL)

USL: A Huge Play On Crude Market Structure – The United States 12 Month Oil ETF, LP (NYSEARCA:USL)

by TradingETFs.com
USL: A Huge Play On Crude Market Structure - The United States 12 Month Oil ETF, LP (NYSEARCA:USL)


Over the last few days, I’ve been on a kick of digging into unique energy ETFs and figuring out the mechanics of how they work and exploring how they should perform in today’s market regime. Today is no different in that I’ve recently been exploring USCF Investments’ United States 12 Month Oil Fund (USL). It is my belief that USL currently represents a good buy based on market dynamics, but investors interacting with USL should be aware of the heavy roll-yield exposure and the diminished volatility of the instrument.

As I began exploring the USL ETF’s prospectus, I had a burning question in my mind: why? You see, USL is billed as an instrument that gives exposure to the price of WTI and instead of holding the front-month contract and rolling to the next month (like USCF Investments’ popular USO ETF), it rather holds 12 months of futures and shifts the position of the first contract to the back of the curve before the first month expires. In other words, it’s always holding a year’s worth of WTI contracts spread across the entire curve.

If you’re familiar with mechanics of a futures curve, you realize there are two key issues at stake when an investor averages a position across multiple months.

First, in general, the front of the curve is typically more volatile than the back of the curve. You almost don’t need to quantify this statement in that it’s close to being a law of most liquid and active futures contracts, but here is a chart showing the 30-day standard deviation of the front 4 WTI contracts to make the case.

As you can see, there’s a clear relationship – the further out on the curve, the lower the daily volatility. When USL holds 12 contracts, it’s greatly diminishing the volatility of the holdings. This means that if an investor is wanting exposure to the flat price of crude oil, they need to consider using leverage if they want to achieve anything comparable to the volatility seen in the front month.

The second key issue investors are exposed to when they invest across multiple months is roll yield. If you’ve read my articles for some time, you’re aware that while a number of the instruments I write about are impacted by roll yield, I don’t always write about all of the ramifications of it. In this article, I need to do a deeper dive on roll yield for one simple reason: USL is a massive bet on market structure.

Let’s start with the basics. Roll yield is the gain or loss you receive on an investment through time as your holdings across multiple futures months converge towards the front-month contract price. Basically, there’s a phenomenon in the futures market in which in general no matter the shape of the forward curve, as the days go by, contracts tend to gradually trade towards the contract in front of them on the curve.

This means that if the market is in backwardation (a state in which the front of the curve is above the back of the curve), contracts in the back months will gradually approach contracts at the front of the curve by increasing in value on a relative basis. If the market is in contango (a state in which the front of the curve is below the back of the curve), the contracts in the back months will gradually approach the contracts in the front months by decreasing in value on a relative basis.

For the holders of USL, this is incredibly relevant because USL is a massive bet on roll yield. Since USL spreads its holdings across 12 months, this means that it is constantly exposed to roll yield. This is a huge driver of returns in USL. For example, here is a comparison of the returns of USO and USL. If you’re familiar with USO, it basically rolls during a fixed window which means that roll yield isn’t a constant feature unlike with USL.

This relationship is very interesting in that it shows that USL’s performance versus USO is largely driven by market structure to a significant degree. This powerfully demonstrates the ramifications of holding positions across 12 months: your holdings are incredibly impacted by market structure.

What this basically boils down to is this: if you can predict market structure, you can largely predict most of USL’s general price movements versus alternatives as well as explain a significant portion of price movements. We’re in luck in that there are a few key fundamental variables which correlate nicely with market structure.

Length prevents me from doing a full fundamental analysis (here’s my recent deep dive), but a primary analytic we can use is the difference between the 5-year average of inventories and the current inventory level. This chart shows the relationship between this variable and market structure.

This relationship is pretty straightforward and makes intuitive sense. When the market is drawing down inventories, market structure should be strengthening towards backwardation or weaker contango because falling stocks signal greater immediate demand than supply and, therefore, higher prices for the product now rather than later. When the market is building stocks versus the 5-year average, market structure should be weakening into contango or trading in that direction because the market is signaling that less supply is needed now and it should be stored for later use.

This relationship can be clearly seen on the chart in periods like July 2017 through July 2018 and October 2018 through March 2019. Remember our chart showing the correlation between USL and changes in market structure? The market structure data point is just a 30-day change in the line chart above.

For investors in USL, the present thesis is pretty clear. We are likely to see immediate draws into the next few months as we enter driving season at an already depressed level of inventories versus historic levels. As you can see in the following chart, we have seen one of the weakest year-to-date builds in inventories ever and we are rapidly approaching driving season when draws become the norm.

In light of the immediate fundamentals, I expect market structure to tighten and trade further into the territory of backwardation. This is a primary driver of USL’s price movements, and therefore, I believe USL makes for an excellent buy while this condition remains. I suggest holding USL until demand subsides with the end of summer driving season.

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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