A nice ride on rising oil prices

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I love the idea of exchange-traded funds (ETFs). They are an easy and cheap way to get exposure to a broad basket of stocks and commodities. I mean, why pay a fund manager 2% of your fund every year when he can't even beat the FTSE 100? Better to buy a FTSE 100 ETF where the manager simply buys all the FTSE 100 constituents for you and charges something like 0.5% a year for his troubles.

The thing is, I've always maintained that investors should steer well clear of ETFs following commodities.

But I've just changed my mind. In fact, the very reason I used to steer clear of these ETFs has now spun round 180 degrees. Where other investors have been facing unnecessary losses for years, you can now make a profit.

Today I'll show you how.

A nasty side effect from commodity ETFs

ETFs have become a popular way to buy a basket of stocks or an index. But when it comes to commodities, things aren't so simple. The ETF provider can't easily buy thousands of barrels of oil, or containers loaded full of corn, or wheat in the market. Where's he going to store it all? What's to stop it going off?

Instead, the ETF loads up on futures contracts...

Say the ETF is designed to follow the crude oil price, it'll buy a contract for oil with a delivery date in the future - say next December. Now, because the ETF manager doesn't want to take delivery of the oil, he'll have to sell the contract before December or he may end up with a boat-load of oil to pick up at Felixstowe!

With the proceeds from the sale of the future contract, he buys a new contract, with delivery for the following December. The process is known as 'rolling over' the contract, and it means he's always got exposure to the oil price.

But there's a problem: generally, future contracts are more expensive than expiring ones; a phenomenon called contango. It reflects finance and storage costs and the extent to which traders are bullish on the oil price. Selling a cheap contract and buying an expensive one is obviously bad business. It means commodity ETFs generally end up with a 'negative roll yield'; ie over the long run, your investment is gradually eroded.

Many commodity ETF holders have been horrified to see the value of their ETF fall despite a rise in the underlying commodity.

But things have changed...

You can now profit from a positive roll yield

Right now many commodity futures contracts are cheaper than the spot price. For example, here's a table of oil price futures:

Source: Barchart.com

As you can see, the futures contracts are cheaper the further out you go. In technical parlance, it's known as 'backwardation' (as the natural state is for dearer futures for longer dates).

So now when it comes to rolling over the futures, the ETF will be selling expensive contracts and buying cheaper ones. Wayhey! A positive roll yield! And that's on top of any uplift in the oil price.

In fact, even if oil prices stay flat, the ETF should still go up as future contracts they bought cheaply mature at, or close to, the spot price.

But - and this is a big but - clearly the market doesn't believe high oil prices will last. The ETF is currently buying cheap oil futures because the market assumes the price of oil is going down.

The market sees today's highs as being down to one-off factors that will reverse - Iranian sanctions (and the threat of military action) and other supply pinches, like Hurricane Isaac, which are assumed to be transient.

But I beg to differ.

Ten reasons why oil will stay high

1. Maturing oil fields in Saudi Arabia, the North Sea and Gulf of Mexico point to dwindling production.

2. Lack of investment means exploration is well below where it should be. Future supply isn't enough to meet global requirements not at current prices, anyway.

3. Though gas supply is increasing, it can't replace oil. Many talk about the two markets inter-changeably, but they are not the same thing.

4. Energy nationalisation is back in fashion. Be it in Venezuela, Argentina, or Saudi Arabia, local politicians are increasingly looking after their own. Exports are dropping off.

5. The markets seem to think that shale production is going to bring on large-scale production. But this is largely a North American phenomenon. I'm buying Brent crude - its price is increasingly parting from its US equivalent.

6. Production costs are rising, in part because of the oil price itself. Offshore, onshore, whatever we're paying more to extract the stuff. If the oil price slips, the oil companies will hold back on projects and the price will recover quickly.

7. China has got stacks of cash, but not enough natural resources. They're on an international buying spree. As they buy production capacity in the likes of Africa, there's less to go round for everyone else. A select group of emerging-market countries are snapping up supply.

8. Emerging market demand won't be slipping any time soon.

9. The Fukushima disaster has turned many off nuclear energy. Sustainable production can't replace it, so it's back to fossil fuels for many.

10. 'Black swans' seem to be procreating and an economic disaster may not be far away. The seeds are certainly sown for a 'once in a lifetime' flare-up. I've long suspected a breakdown in the financial system as we know it - a financial system 'reboot' is how I like to look at it. To protect any 'saved work' you'll want some tangible assets. Oil in the ground is one of them. The oil price will quickly respond to a new monetary system.

'Backwardation' isn't the only reason to be long a crude oil ETF. But it's a handy kicker that should give its performance a little boost.

Of course, I urge you to do your own research on which oil ETF you buy.

Here is a list to get you started.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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