With a lofty roll yield, powershares db oil fund looks attractive – powershares db oil etf (nysearca dbo) seeking alpha electricity youtube

I may be the only author writing on oil ETFs that doesn’t have a strong opinion on oil prices. Many years ago, I worked as an analyst on an energy trading desk. I’d talk to one trader who’d convince me that energy prices were going up. I’d then talk to another trader who’d convince me that energy prices were going down. From that and other experiences I learned that macroeconomic forecasting wasn’t my game.

So why the heck I am writing an article on oil ETFs? Well, recently oil futures have become more attractive than they have been in years. Oil futures have moved from contango, which is terrible for futures investing, into backwardation, which is great for futures investing. Also, oil prices are also exhibiting positive momentum that also tends to be predictive of positive future returns.

Both backwardation and momentum are well known to be predictors of excess returns in commodity futures. I’m linking to a fairly readable Morningstar article that explains this, but numerous references abound in financial journals and articles across the internet. Oil Futures Have Been A Terrible 10-Year Investment

The poor returns have partly been due to a decrease in spot oil prices from $100ish to $60ish, but an even bigger part is the fact that oil futures have been in contango for most of this time period. As noted in an article by ThinkAdvisor between October 9, 2008 and June 19, 2013, spot crude oil prices returned 10.5% while USO returned -51.9%. According to ThinkAdvisor, USO’s underperformance was due to an average contango of $0.87 during 98.4% of that time period, although USO’s expenses also contributed.

What’s more, oil markets have been in contango for most of the past 3 years. Last November, oil markets shifted into backwardation for the first time since November 20, 2014. To be honest, I was "asleep at the wheel" on this change because oil had been in contango so long that I wasn’t even considering it as an investment.

Anyway, the shift has made oil futures a much more attractive investment in my view and is the reason why I’m not running away from the market, even with a chart like that of USO. We will look more closely at this backwardation below. Why Backwardation and Contango Are Critical To Futures Investing

In backwardation, the futures price is cheaper than the spot price. By buying the futures, you are "getting a discount" to the spot price. Your return to holding the futures contract to maturity will be the spot price return plus the discount.

The premium/discount you pay/earn from holding futures is also called the "roll yield," a name which derives from the process of "rolling" futures contracts, which involves trading out of an expiring futures contract into a futures contract expiring at a later date. Roll yield is positive in backwardated markets and negative in contango markets. Current Oil Market Backwardation Is Attractive

To keep the analysis simple, let’s use June 2018 futures prices as a proxy for spot oil prices. From the above chart, you see that oil in June 2019 is $6.23 cheaper than oil in June 2018. If spot oil prices stay flat over the next year, you will earn $6.23/$61.50 or 10.1% in roll yield from holding the June 2019 oil futures. Why I Like Oil Futures Now

With oil futures in backwardation, the one-year roll yield of 10.1% is attractive enough for me to want to buy futures. For that reason, I am not worried about the poor historical returns from oil futures, as they mostly occurred in periods of contango. They also started from a much higher base oil price than we have now.

This is not to say, I’m pounding the table for oil. I don’t know what lies in store for spot oil prices, but I do know that backwardation and positive momentum (which we have with the recent uptick in oil) tend to lead to positive returns in commodity futures.

What’s more, commodities such as oil diversify a stock portfolio and can offset the risk from certain global shocks. In finance speak, commodities tend to have positive event tail risk, while stocks tend to have negative event tail risk. For example, war in the Middle East would likely have a negative impact for stocks, but a positive impact for oil. For all those reasons, I am making a modest allocation to an ETF that invests in oil futures.

USO buys the near-month oil futures contract. Using the chart above, you see that you only pick up $0.17 from rolling the June 2018 contract into the July 2018 contract. If you annualize this one-month roll, you earn roughly a 3% roll yield, which is much lower than the 10.1% roll yield I found by buying the futures contract one year out.

Rather than select a new futures contract based on a predetermined schedule (e.g., monthly), each Index Commodity is rolled from one contract to another futures contract that is intended to generate the most favorable “implied roll yield” under prevailing market conditions.

Since I am in the investment for the roll yield and not my ability to forecast oil prices, DBO fits me perfectly. Currently DBO is invested in the CLH9 contract (March 2019), which I estimate has an 8.6% annualized roll yield. Although the roll yield for March 2019 is slightly less attractive than June 2019, you also have to factor in the cost of trading in and out of futures. It only makes sense for DBO to switch futures contracts if the incremental roll yield offsets the trading costs of rolling futures. Also, DBO resets its portfolio periodically, so it will not necessarily trade out of its position as a result of the futures curve on a given day.