Feeling whipped?
Well, if you tried to cleverly use the oil market as an inflation hedge, you could very well be swayed by the market’s recent price action.
May your intentions be noble. Ultimately, the effect of oil on inflation is significant. In his recent testimony before the Senate Banking Committee, Federal Reserve Chairman Jerome Powell offered this rule of thumb: Every $10 increase in the barrel price of crude leads to a 0.2% increase in inflation.
Crude oil continued to rise from the COVID-19-induced slump in 2020, feeding off latent inflation concerns among investors and their advisors alike, only to rebound wildly over news of the Russian invasion of Ukraine.
You’d think this would be good news for buyers of oil ETF hedges. And maybe it was. Then again, maybe not. After West Texas Intermediate crude hit a high of $130 a barrel a week ago, prices fell sharply to pre-attack levels below $100. That’s still well above their pandemic levels, but how many of us have bought less?
And how many of us chose the right hedge in the first place? Or at the right time? After all, there’s more than one way to use the oil market to hedge against inflation.
First, there is the oil itself. You can get information about next month’s WTI future prices through United States Oil Fund (USO), The month ahead you ask? It is simply a futures contract with the closest delivery date, which is most sensitive to current demand.
If you want continued exposure to oil – as you would in a hedge that lasts longer than a month – you need to allow for the pricing dynamics of the futures market. For the USO to maintain its front-month exposure, it must continuously “roll” its future holdings as its contract nears expiration. Simply put, the fund must sell the expiring contracts in order to buy the next delivery month. When oil is in short supply, the future curve is in favor of USO buyers. Front-month contracts are typically bid-ask, indicating a demand for immediate delivery, while back-month futures are priced at a discount. On a roll in a tight market, a premium can be earned because the contract with the higher price is traded for discounted futures, that is, “sell high, buy low.”
The opposite is true when a “contango” exists, that is, when oil is plentiful – as was the case in the depths of the pandemic – and front-of-month futures are cheaper than far-delivery. The market constantly falters between contango and vice versa (known as “backwardness” or “inversion”). Over the past five years, for example, the WTI market has been upside down 53% of the time, encouraging long oil hedges. The rest of the time, such a defense was costly.
You can avoid the uncertainty of the futures market by using oil sector ETFs instead. $6 billion in equity funds representing integrated oil operators SPDR S&P Oil & Gas Exploration and Production ETF (XOP) The biggest XOP tracks an equal-weighted index of companies involved in the discovery of new oil and gas deposits such as Chevron Corp., Occidental Petroleum Corp. and Marathon Oil Corp.
Next the oil service sector is estimated by VanEck Oil Services ETF (OIH), a cap-weighted collection of large energy equipment and service parts. OIH’s portfolio includes Halliburton Co., Schlumberger NV and 23 others.
Finally, the downstream segment of the oil market, represented by VanEck Oil Refiners ETF (CRAK) Can be used as a potential hedge. Named for the so-called “crack spread” — the price difference between the cost of crude oil and the sales proceeds of refined output products — CRAK’s 25 components include organizations such as Phillips 66, Valero Energy Corp. and Marathon Petroleum Corp., among others.
Amidst all the volatility over the past five years, it is telling that only one of these oil risks is now above water. CRAK is growing at a compound annual growth rate of 5.8% with market-like volatility of 24.6%. All other oil ETFs—even the crude oil embodiment, USO—have had negative average annual returns since 2017.
OIL ETF’s Five Year Track Record
Work is going on here that the rift has widened and it is affecting the profits of the refiners. Gross refining margins tend to be more stable than crude oil prices because refiners can reduce their production of outputs such as gasoline and fuel oil to meet demand. Consumers’ thirst for gasoline—and its price—peaks during the driving months of the summer, while competition for heating oil supplies peaks in the winter. Refiners adjust their production mixes to meet this offsetting seasonality to keep their margins consistent.
All told, a hedger using the CRAK is in for a smoother ride than a user of the USO or other oil field ETFs. For a more conservative portfolio, small bumps and shallow pits in the CRAK’s price trajectory make hedge entry and exit timing less important. And this makes it more likely that CRAK can be kept in the portfolio exactly when it is needed most.
Brad Ziegler is WealthManagement’s Alternative Investments Editor. Previously, he was the head of marketing, research and education for the Pacific Exchange (now NYSE Arca) options market and the iShares complex of exchange-traded funds.
