Oil prices have fallen 60%+ from the highs of this year, then rallied 40% from its lows a week ago on back of President Trump trying to engineer a deal between Saudi Arabia and Russia, compelling them to call off their “silly” price war. Driven by greed and FOMO, all this volatility has retail investors once again eyeing the Oil market, asking the age old question: “How can I go long Oil?”
The best and cleanest way to trade Oil is through Oil futures itself. It also means that a retail investor would need to know when the futures contract expires and make sure to cash settle it, lest a physical barrel of Oil appears on their doorstep! Not a convenient position to be in I assure you. Oil futures are also extremely volatile and risky compared to other asset classes. Unlike Equities where one can ascertain some floor value from its physical assets or book value, Commodities differ in that there is no floor nor ceiling. It is purely driven by demand vs. supply and inventory balances. If a Commodity is in demand, then the price can go as high till the next buyer is willing to pay or until supply catches up. Alternatively, if you do not need it, then no matter the price, you will not be willing to pay anything for it. Commodities can trade close to 0 or negative even given the right circumstances.
A Commodity curve is derived by plotting the price of the contract for every month going forward. The price of an Oil ETF is basically the price of the front month Oil futures contract held in your account, which is then rolled off at the end of every month to buy the next month contract. One of the benefit holding the ETF vs. holding the outright future is that the ETF does this roll automatically for you. However, this is where it can get very complicated. The Oil price can be up 40%, but a retail investor holding the Oil ETF can still be down 10%. Why you may ask?
It is because of the shape of the Oil curve. The curve can be in “backwardation” (futures price is above the spot price) or in “contango” (futures price is lower than the spot price). Physical Oil markets determine the shape of the Oil curve; it is not a static price as it constantly moves up and down based on physical market balances. If you are long the Oil ETF, you can either make a lot more money than you expected (a backwardated structure leading to a positive carry roll every month) or lose a lot more (a contango structure leading to a negative carry roll every month). If you simply hold the ETF for a long time, you can give away all your performance regardless of what the Oil price does based on storage and curve dynamics.
One can also buy the back end longer term Oil futures contract trading 1 or 2 years out. They are a lot less volatile and perhaps best reflect the true underlying demand for Oil. But these do not appeal to retail investors looking to make outsized gains as they have a lot less trading potential.
The best way to play Oil is via the Equities, but this requires detailed fundamental work on balance sheets, cost of production, geological potential, and debt profiles. There are times when there is more value in the respective Equities or in the Commodity. One can dynamically choose to play the long in one or the other.
It is like a dynamically evolving 3D matrix driven by geopolitics, physical market imbalances, and company fundamentals. There is no simple answer.