by Michael Johnston on April 15, 2010 | Updated November 13, 2012 | ETFs Mentioned: OIL • USO
With the summer driving season just around the corner, surging GDP growth around the world, and another earnings season off to an impressive start. more and more investors are taking a closer look at oil markets. As OPEC begins to once again flex its collective muscle and demand from emerging markets continues to build, some see crude prices surging in coming months, perhaps teasing the $100 per barrel level last touched in September 2008 [see Free Report: Everything You Need To Know About Commodity ETFs ].
Historically, investors looking to make a play on rising oil prices did so through equities of energy companies that often enjoy a jump in profitability when crude prices spike. But the rise of the ETF industry has changed the way many investors approach commodity investing, bringing many securities that were once available primarily to institutional traders within reach. While exposure to spot oil prices still isn’t readily available, the development of futures-based commodity products allows more direct exposure to one of the world’s most widely-used resources.
Two of the most popular exchange-traded commodity products available to U.S. investors offer exposure to crude oil. The iPath S&P GSCI Crude Oil Total Return Index ETN (OIL ) and United States Oil Fund (USO ) had aggregate assets of more than $2 billion at the end of the first quarter, and are two of the most popular ways to gain exposure to oil prices. While the risk/return profiles presented by these two ETPs are generally similar, there are both subtle and not-so-subtle differences that can potentially have a big impact on returns and volatility (see all ETFs offering exposure to oil prices in the Oil & Gas ETFdb Category and a complete breakdown in the Guide To Crude Oil ETF Investing ).
The biggest difference between USO and OIL is in the structure of each. OIL is an exchange-traded note (ETN), meaning that it is a senior, unsubordinated, unsecured debt security that is linked to the total return
of a market index (in this case, the S&P GSCI Crude Oil Total Return Index ). The benchmark to which OIL is linked is a sub-index of the S&P GSCI Index and reflects the returns that are potentially available through an unleveraged investment in West Texas Intermediate (WTI) crude oil futures contracts plus the T-Bill rate of interest that could be earned on uninvested cash [see Actionable ETF Trading Ideas ].
USO, on the other hand, seeks “to reflect the changes in percentage terms of the spot price of light, sweet crude oil…as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the [NYMEX].” To accomplish this goal, USO invests in NYMEX futures contracts and cash (the daily holdings are available here ). So since USO actually holds the assets from which the returns of OIL are derived, the returns will generally be highly correlated, but not identical.
It’s important to understand the risks and benefits of investing in an ETN. While it’s unlikely that Barclays Bank, the issuer of OIL, will go bankrupt, credit risk should never be completely ignored (as investors in ETNs issued by Lehman learned the hard way). So that’s the downside of investing in an ETN; if the issuer goes under, investors get in line with the rest of the creditors. If United States Commodity Funds were to go under, investors in USO would have claim to the fund’s underlying assets.
On the flip side, since there are no assets to manage ETNs will generally have lower tracking error and sometimes lower expense ratios. Whereas USO must roll its holdings each month–which means going out into the market and buying and selling securities–the value of OIL is a simple calculation based on market prices. Overhead and potential for tracking error are minimal.
Both OIL and USO charge higher expense ratios than most energy ETFs that consist of big oil firms. USO charges a total expense ratio of 0.96%, while OIL’s annual fee is 0.75%. By comparison, the Energy Select Sector SPDR (XLE ) charges 0.21%.