Description
TalkingPoints
The Oil Effect
Jodie Gunzberg, GLOBAL HEAD OF COMMODITIES, S&P DOW JONES
INDICES
Dig deeper into the economic effects and potential opportunities surrounding
recent drops in oil.
1. Why is oil such a hot topic right
now?
®
In the past year, the S&P GSCI Crude Oil (TR)
has dropped about 60%. The precipitous drop in
price has moved oil into the forefront of
macroeconomic factors where it may be the only
positive risk powerful enough to offset other
risks like market volatility, geopolitical risk,
stagflation, and lower investment. This is
important for the formation of global GDP
forecasts that have been more erratic than ever.
If oil prices stabilize near current levels, then
credit risk may increase, causing assets to shift
based on Fed actions, like in the risk-on risk off
environment seen after the global financial
crisis.
The economy, which is still in a postglobal transition, is highly sensitive to these factors. 2. What are the investment considerations now from the oil drop? The winners and losers are divided across the world by whether countries are importers or exporters. It also depends on what their breakeven oil prices are—that is, where it is no longer profitable to produce oil.
Furthermore, for countries, it depends on their budget surplus or deficit levels and their individual tax policies. Understanding equity opportunities is similar to knowing how much a company produces or consumes, what levels are profitable, and how much cash it has. However, investing in companies is different, since management may choose to hedge out the oil price volatility and make decisions for shareholders. Historically, the correlation between oil and its respective producers is about 0.65, much less than the 0.99 correlation between oil spot return and total return in the futures market. 3.
If the correlation is so high between the oil spot return and total return in the futures market, then what is the difference? Before describing the difference, it is helpful to know that the similarity comes from the fact that the spot return is used to calculate the total return. There are three parts to the calculation of a total return index of commodity futures. The first part is the spot return, which reflects only the prices of the futures contracts with the first nearby expiration dates or during the roll period expirations (the time period when exiting the expiring contracts and entering later dated contracts).
The advantage of using an index methodology to calculate the spot return rather than just using the contract itself is that there is a defined way to link the prices between the expiring contract and the new contract for continuous value. The next part of the total return is called the roll return or roll yield. It measures the premium or discount obtained by rolling positions forward as they approach .
The Oil Effect? delivery. The excess return version of a commodity futures index includes the roll yield plus the spot return. Finally, the total return index includes the spot return, roll yield, and the third calculation piece called the collateral return. The collateral return is the interest earned on any fully collateralized contract positions on the commodity futures.
Therefore, to finally answer the question, the difference between the oil spot return and total return in the futures markets comes from the roll yield and the interest earned on collateral. 4. Given interest rates are basically zero today, is it correct to assume the difference is coming from the roll yield? Currently, the difference is from the roll yield, though historically this has not always been the case. On average since 1987, there has only been a slightly negative roll yield of 2 bps per month, while the average collateral return has been 29 bps.
The near-zero average roll yield is sometimes positive and sometimes negative. Generally, the roll yield is positive when there is a shortage, a condition measured in about 45% of months, adding on average 1.7% in those months. Conversely, in about 55% of months, the roll yield is negative, reflecting excess inventory, detracting 1.4% on average. 5. Then does it make more sense to pay attention to the spot, excess, or total return? In 92% of months, the spot return goes in the same direction as the total return, and given it is the closest proxy to the actual cash oil price, it is undoubtedly important.
However, the roll yield, the additional piece of the excess return calculation, is a cyclical factor that can be managed to enhance returns from a basic index strategy holding the front month contract. Marginally, it is more expensive to store inventory in the earlier months, so enhanced indexing, known as smart beta, can hold later dated contracts to reduce the negative roll yield during times of excess inventory. The collateral yield is important since it provides the expected TalkingPoints inflation plus the real rate of return. It matters for investors looking for the asset class return to provide full inflation protection, and not just against unexpected inflation. 6.
How might investors evaluate the right index strategy for their oil exposure? Most investors use oil in a portfolio context for diversification, inflation protection, and as a geopolitical hedge. However, oil on a standalone basis has a historical annualized volatility of about 33%, which can be high for some investors. Therefore, those investors may like to mix oil with other commodities to reduce the volatility within a well-diversified basket.
For example, the S&P GSCI, the world-production weighted flagship commodity index that currently has the highest weight in oil at about 60%, has an annualized volatility of only 19%, which is significantly less than 33% of oil alone and is only slightly higher than the historical volatility of ® the S&P 500 at 15%. The more oil, the higher the diversification benefit and the higher the inflation protection there has been for investors historically. While those are possibly attractive qualities of an index with oil, there is concern about the negative roll yield from the first nearby expiration contract.
In fact, the recent oil drawdown forced the spot index to its lowest levels since 2009, but the negative roll yield has cost investors an extra 10 years of return, dropping the total return index to levels not seen since 1999. For investors concerned about that, there are several modified choices that hold forward contracts always or at certain times based on the roll yield. The most advanced strategies may change contracts dynamically on a monthly basis using expirations out to 48 months; however, there may be a liquidity tradeoff for the extra roll yield.
The reduced liquidity fits the requirement of many investors, but for some extremely large plans or plans with very high sensitivity to liquidity, the tradeoff may be less attractive than holding contracts that expire sooner. LIKE WHAT YOU READ? Sign up to receive updates on a broad range of index-related topics and complimentary events. 2 . The Oil Effect TalkingPoints GENERAL DISCLAIMER © 2015 by S&P Dow Jones Indices LLC, a part of McGraw Hill Financial, Inc. All rights reserved. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of McGraw Hill Financial. Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Trademarks have been licensed to S&P Dow Jones Indices LLC.
Redistribution, reproduction and/or photocopying in whole or in part are prohibited without written permission. This document does not constitute an offer of services in jurisdictions where S&P Dow Jones Indices LLC, Dow Jones, S&P or their respective affiliates (collectively “S&P Dow Jones Indices”) do not have the necessary licenses. All information provided by S&P Dow Jones Indices is impersonal and not tailored to the needs of any person, entity or group of persons.
S&P Dow Jones Indices receives compensation in connection with licensing its indices to third parties. Past performance of an index is not a guarantee of future results. It is not possible to invest directly in an index. Exposure to an asset class represented by an index is available through investable instruments based on that index.
S&P Dow Jones Indices does not sponsor, endorse, sell, promote or manage any investment fund or other investment vehicle that is offered by third parties and that seeks to provide an investment return based on the performance of any index. S&P Dow Jones Indices makes no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. S&P Dow Jones Indices LLC is not an investment advisor, and S&P Dow Jones Indices makes no representation regarding the advisability of investing in any such investment fund or other investment vehicle.
A decision to invest in any such investment fund or other investment vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are advised to make an investment in any such fund or other vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or other vehicle. Inclusion of a security within an index is not a recommendation by S&P Dow Jones Indices to buy, sell, or hold such security, nor is it considered to be investment advice. These materials have been prepared solely for informational purposes based upon information generally available to the public and from sources believed to be reliable.
No content contained in these materials (including index data, ratings, credit-related analyses and data, research, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse-engineered, reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of S&P Dow Jones Indices. The Content shall not be used for any unlawful or unauthorized purposes. S&P Dow Jones Indices and its third-party data providers and licensors (collectively “S&P Dow Jones Indices Parties”) do not guarantee the accuracy, completeness, timeliness or availability of the Content.
S&P Dow Jones Indices Parties are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the Content. The Content is provided on an “as is” basis. S&P DOW JONES INDICES PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Dow Jones Indices Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages. S&P Dow Jones Indices keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities.
As a result, certain business units of S&P Dow Jones Indices may have information that is not available to other business units. S&P Dow Jones Indices has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. In addition, S&P Dow Jones Indices provides a wide range of services to, or relating to, many organizations, including issuers of securities, investment advisers, broker-dealers, investment banks, other financial institutions and financial intermediaries, and accordingly may receive fees or other economic benefits from those organizations, including organizations whose securities or services they may recommend, rate, include in model portfolios, evaluate or otherwise address. The Global Industry Classification Standard (GICS®) was developed by and is the exclusive property and a trademark of Standard & Poor’s Financial Services LLC (“S&P”) and MSCI Inc (“MSCI”). Neither MSCI, S&P nor any other party involved in making or compiling any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such standard or classification.
Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. 3 .
The economy, which is still in a postglobal transition, is highly sensitive to these factors. 2. What are the investment considerations now from the oil drop? The winners and losers are divided across the world by whether countries are importers or exporters. It also depends on what their breakeven oil prices are—that is, where it is no longer profitable to produce oil.
Furthermore, for countries, it depends on their budget surplus or deficit levels and their individual tax policies. Understanding equity opportunities is similar to knowing how much a company produces or consumes, what levels are profitable, and how much cash it has. However, investing in companies is different, since management may choose to hedge out the oil price volatility and make decisions for shareholders. Historically, the correlation between oil and its respective producers is about 0.65, much less than the 0.99 correlation between oil spot return and total return in the futures market. 3.
If the correlation is so high between the oil spot return and total return in the futures market, then what is the difference? Before describing the difference, it is helpful to know that the similarity comes from the fact that the spot return is used to calculate the total return. There are three parts to the calculation of a total return index of commodity futures. The first part is the spot return, which reflects only the prices of the futures contracts with the first nearby expiration dates or during the roll period expirations (the time period when exiting the expiring contracts and entering later dated contracts).
The advantage of using an index methodology to calculate the spot return rather than just using the contract itself is that there is a defined way to link the prices between the expiring contract and the new contract for continuous value. The next part of the total return is called the roll return or roll yield. It measures the premium or discount obtained by rolling positions forward as they approach .
The Oil Effect? delivery. The excess return version of a commodity futures index includes the roll yield plus the spot return. Finally, the total return index includes the spot return, roll yield, and the third calculation piece called the collateral return. The collateral return is the interest earned on any fully collateralized contract positions on the commodity futures.
Therefore, to finally answer the question, the difference between the oil spot return and total return in the futures markets comes from the roll yield and the interest earned on collateral. 4. Given interest rates are basically zero today, is it correct to assume the difference is coming from the roll yield? Currently, the difference is from the roll yield, though historically this has not always been the case. On average since 1987, there has only been a slightly negative roll yield of 2 bps per month, while the average collateral return has been 29 bps.
The near-zero average roll yield is sometimes positive and sometimes negative. Generally, the roll yield is positive when there is a shortage, a condition measured in about 45% of months, adding on average 1.7% in those months. Conversely, in about 55% of months, the roll yield is negative, reflecting excess inventory, detracting 1.4% on average. 5. Then does it make more sense to pay attention to the spot, excess, or total return? In 92% of months, the spot return goes in the same direction as the total return, and given it is the closest proxy to the actual cash oil price, it is undoubtedly important.
However, the roll yield, the additional piece of the excess return calculation, is a cyclical factor that can be managed to enhance returns from a basic index strategy holding the front month contract. Marginally, it is more expensive to store inventory in the earlier months, so enhanced indexing, known as smart beta, can hold later dated contracts to reduce the negative roll yield during times of excess inventory. The collateral yield is important since it provides the expected TalkingPoints inflation plus the real rate of return. It matters for investors looking for the asset class return to provide full inflation protection, and not just against unexpected inflation. 6.
How might investors evaluate the right index strategy for their oil exposure? Most investors use oil in a portfolio context for diversification, inflation protection, and as a geopolitical hedge. However, oil on a standalone basis has a historical annualized volatility of about 33%, which can be high for some investors. Therefore, those investors may like to mix oil with other commodities to reduce the volatility within a well-diversified basket.
For example, the S&P GSCI, the world-production weighted flagship commodity index that currently has the highest weight in oil at about 60%, has an annualized volatility of only 19%, which is significantly less than 33% of oil alone and is only slightly higher than the historical volatility of ® the S&P 500 at 15%. The more oil, the higher the diversification benefit and the higher the inflation protection there has been for investors historically. While those are possibly attractive qualities of an index with oil, there is concern about the negative roll yield from the first nearby expiration contract.
In fact, the recent oil drawdown forced the spot index to its lowest levels since 2009, but the negative roll yield has cost investors an extra 10 years of return, dropping the total return index to levels not seen since 1999. For investors concerned about that, there are several modified choices that hold forward contracts always or at certain times based on the roll yield. The most advanced strategies may change contracts dynamically on a monthly basis using expirations out to 48 months; however, there may be a liquidity tradeoff for the extra roll yield.
The reduced liquidity fits the requirement of many investors, but for some extremely large plans or plans with very high sensitivity to liquidity, the tradeoff may be less attractive than holding contracts that expire sooner. LIKE WHAT YOU READ? Sign up to receive updates on a broad range of index-related topics and complimentary events. 2 . The Oil Effect TalkingPoints GENERAL DISCLAIMER © 2015 by S&P Dow Jones Indices LLC, a part of McGraw Hill Financial, Inc. All rights reserved. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of McGraw Hill Financial. Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Trademarks have been licensed to S&P Dow Jones Indices LLC.
Redistribution, reproduction and/or photocopying in whole or in part are prohibited without written permission. This document does not constitute an offer of services in jurisdictions where S&P Dow Jones Indices LLC, Dow Jones, S&P or their respective affiliates (collectively “S&P Dow Jones Indices”) do not have the necessary licenses. All information provided by S&P Dow Jones Indices is impersonal and not tailored to the needs of any person, entity or group of persons.
S&P Dow Jones Indices receives compensation in connection with licensing its indices to third parties. Past performance of an index is not a guarantee of future results. It is not possible to invest directly in an index. Exposure to an asset class represented by an index is available through investable instruments based on that index.
S&P Dow Jones Indices does not sponsor, endorse, sell, promote or manage any investment fund or other investment vehicle that is offered by third parties and that seeks to provide an investment return based on the performance of any index. S&P Dow Jones Indices makes no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. S&P Dow Jones Indices LLC is not an investment advisor, and S&P Dow Jones Indices makes no representation regarding the advisability of investing in any such investment fund or other investment vehicle.
A decision to invest in any such investment fund or other investment vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are advised to make an investment in any such fund or other vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or other vehicle. Inclusion of a security within an index is not a recommendation by S&P Dow Jones Indices to buy, sell, or hold such security, nor is it considered to be investment advice. These materials have been prepared solely for informational purposes based upon information generally available to the public and from sources believed to be reliable.
No content contained in these materials (including index data, ratings, credit-related analyses and data, research, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse-engineered, reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of S&P Dow Jones Indices. The Content shall not be used for any unlawful or unauthorized purposes. S&P Dow Jones Indices and its third-party data providers and licensors (collectively “S&P Dow Jones Indices Parties”) do not guarantee the accuracy, completeness, timeliness or availability of the Content.
S&P Dow Jones Indices Parties are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the Content. The Content is provided on an “as is” basis. S&P DOW JONES INDICES PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Dow Jones Indices Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages. S&P Dow Jones Indices keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities.
As a result, certain business units of S&P Dow Jones Indices may have information that is not available to other business units. S&P Dow Jones Indices has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. In addition, S&P Dow Jones Indices provides a wide range of services to, or relating to, many organizations, including issuers of securities, investment advisers, broker-dealers, investment banks, other financial institutions and financial intermediaries, and accordingly may receive fees or other economic benefits from those organizations, including organizations whose securities or services they may recommend, rate, include in model portfolios, evaluate or otherwise address. The Global Industry Classification Standard (GICS®) was developed by and is the exclusive property and a trademark of Standard & Poor’s Financial Services LLC (“S&P”) and MSCI Inc (“MSCI”). Neither MSCI, S&P nor any other party involved in making or compiling any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such standard or classification.
Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. 3 .
