Commodity Exchange Traded Funds Tim Simard
NBC Commodities 14-person Calgary-based team running both a client-driven and strategic trading operation Collective team experience in excess of 250 years in the field of energy trading and risk management Primarily energy: crude oil, refined products and both physical and financial natural gas strategic trading activities largely to support client-driven business Broad base of corporate flow hedging activity 75% oil and gas producers, + utilities and energy consumers Strong lending franchise supports energy hedging business 140+ transactional clients over the past 24 months Many larger, highly-competitive counterparties Daily commentary circulated to over 1,400 people Trading desks provide the hedge for all the Horizons BetaPro commodity ETFs: Crude, natural gas, gold, silver, copper Largest trader of financial energy derivatives among Canadian banks New activities: WCS (heavy crude) hedging, NGL hedging, natural gas storage, metals trading 2
ETFs are Causing Market Volatility Huh??? Total Crude Oil ETF Contracts versus Prompt WTI 140,000 130,000 120,000 110,000 Price Collapse, ETF Creation Escalation in Price, ETF Redemptions Escalation in Price, ETF Redemptions $160.00 $150.00 $140.00 $130.00 Futures Contract Equivalent 100,000 90,000 80,000 70,000 60,000 50,000 40,000 Escalation in Price, NO ETF Creation $120.00 $110.00 $100.00 $90.00 $80.00 $70.00 $60.00 30,000 20,000 10,000 0 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Apr-09 Jun-09 Jul-09 Sep-09 Nov-09 Feb-10 Apr-10 USD per bbl Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 $50.00 $40.00 $1.6 billion of redemptions $30.00 $20.00 Net Position: USO + HOU - HOD Prompt Month WTI 3
$150 $130 $110 USD per Bbl $90 $70 4 ETFs are Causing Oil Market Volatility Huh??? Total AUM for HOU and HOD versus WTI $0.80 $0.60 $0.40 $0.20 $0.00 ($0.20) ($0.40) $50 $30 CAD Billion Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 HOU HOD Spot NYMEX WTI
ETFs are Causing Oil Market Volatility Huh??? Net HOU and HOD AUM vs WTI $0.80 $150 $0.60 $130 $0.40 $110 CAD Billion $0.20 $90 USD per Bbl $0.00 $70 ($0.20) Short 3,660 futures contracts Short 5,300 futures contracts $50 ($0.40) $30 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 NET HOU and HOD AUM Spot NYMEX WTI 5
ETFs are Causing Natural Gas Market Volatility Huh??? 160,000 150,000 140,000 130,000 Total Natural Gas ETF Contracts versus Prompt NYMEX NG Every time the prompt NYMEX NG contract falls below $4.00, we see massive ETF capital inflows $16.00 $15.00 $14.00 $13.00 120,000 $12.00 Futures Contract Equivalent 110,000 100,000 90,000 80,000 70,000 60,000 50,000 $11.00 $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 40,000 30,000 20,000 10,000 0 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Apr-09 Jun-09 Jul-09 Sep-09 Nov-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 USD per MMBtu $4.00 $3.00 $2.00 $1.00 $- Net Position: UNG + HNU - HND Prompt Month NYMEX NG 6
ETFs are Causing Natural Gas Market Volatility Huh??? Total AUM for HNU and HND versus NYMEX NG $16 $1.20 $14 $1.00 $12 $0.80 USD per Bbl $10 $8 $6 $0.60 $0.40 $0.20 $4 $0.00 $2 ($0.20) $- ($0.40) Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 HNU HND Spot NYMEX NG CAD Billion 7
ETFs are Causing Natural Gas Market Volatility Huh??? Net HNU and HND AUM vs NYMEX NG $16 $1.20 $14 $1.00 $12 $0.80 USD per Bbl $10 $8 $6 $0.60 $0.40 $0.20 $4 $0.00 $2 ($0.20) $- ($0.40) Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 NET HOU and HOD AUM Spot NYMEX WTI CAD Billion 8
The Contango/Backwardation Issue Contango forward prices trading at a premium to spot prices Backwardation forward prices trading at a discount to spot prices theoretically, forward prices represent the consensus market view of future spot market prices At times there can be a structural imbalance between buyers and sellers in the forward curve Unlike many other forward curves (equities, FX, interest rates), frequently arbitrages are not possible to construct a predictable forward curve (especially in a backwardated scenario) E.g. backwardation should never exist Long commodity investors view contango as a cost, backwardation as a benefit 9
The Contango Arbitrage Assume July crude is trading at $90 and August crude is trading at $100 Trader borrows $90 and buys July barrels at $90, injects those barrels into storage at Cushing, Ok., and simultaneously locks in the sales price one month later at $100 Borrowing cost at 3% for one month approximately $0.20 per bbl Storage costs approximately $0.40 per bbl per month Net arbitrage profit: $100 - $90 - $0.60 = $9.40 Traders would continue to buy July and sell August until the arbitrage disappears the July-August market in $0.60 contango What can cause the contango to widen out more than the cost of storage + interest costs? No more storage availability at the delivery point of the futures contract Happened in crude oil in early 2009 Contango moved so wide that traders were incentivized to book tankers and store crude from month-to-month offshore floating storage 10
The Backwardation Arbitrage Assume July crude is trading at $100 and August crude is trading at $90 Trader borrows a barrel of crude for the month of July Trader sells the barrel for delivery in July at $100, and simultaneously enters into a forward purchase in August so he can return the barrel to the lender Trader invests the $100 proceeds and receives interest for the month Assume the cost to borrow the barrel is $1 per bbl Net arbitrage profit: $100 - $90 - $1.00 + $0.20 = $9.20 In this scenario, traders will continue to sell July and buy August until the premium to the July contract falls to $0.80 Major problem: when the market is tight, there is no borrowing market for crude oil There is utility associated with holding the barrel of crude so that it can be consumed E.g. would a Northeast homeowner lend his heating oil when the temperature is -40 degrees? As a result, there is no theoretical maximum to the potential backwardation in the market Spot month crude could be trading at $200 with the 2nd month trading at $100 11
The Contango/Backwardation Issue Contango "Cost" $103 $102 $101 Monthly Contango Roll Purchase Price of $100 $100 $99 USD per Bbl $98 $97 $96 $95 $94 $93 $92 $91 Monthly Roll Sales Price of $95 At the end of six months, long investor is down $30 per barrel, even though it appears that the spot price has not moved 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96 101 106 111 116 121 126 Days 12
Investors Cannot Completely Avoid the Contango Effect The physical purchase alternative: Buy crude today and store it until you want to sell it Cost of term storage $0.40 - $0.50 per bbl If you wanted to buy and hold crude for 5 years, buy crude at $100, pay storage costs of $24 - $30 per bbl Price in 5 years time would have to be greater than $130 to make money! 5-year premium in the oil forward market has never been as high as $30 per bbl The oil producer alternative: Today s share price for an oil producer should be based on price he will receive in the future for his oil E.g. if spot crude is at $100, but the rest of the forward curve out for five years is trading at $110, is the producer s NAV based on $100 or $110? In this scenario, if one purchases the producer s shares based on the $110 forward price and the price ends up actualizing at today s spot price of $100, you should lose money on the equity investment 13
Mitigating the Roll Effect Roll Where the Curve is Flatter Horizons Beta Pro in June 2009 launched two single bull energy ETFs: HBP Winter-Term NYMEX Crude Oil ETF (HUC) HBP Winter-Term NYMEX Natural Gas ETF (HUN) Designed to appeal to longer-term buy-and-hold investors Crude ETF (HUC) tracks the first nearby December contract, rolling once a year in June to the following December Natural gas ETF (HUN) tracks the first nearby January contract, rolling once a year in November to the second nearby January contract Selection of index meant to maximize liquidity while minimizing the contango/backwardation phenomenon December crude contracts the most liquid along the forward curve Rolling from the 6 th month to the 18 th month typically in a flatter part of the curve Largely insulated from movements in the CAD/USD exchange rate 14
Rolling in a Flatter Part of the Curve Current first-versus second month spread $0.65 HUC is rolling with a 12-month spread of $1.20, so just $0.10 per bbl per month WTI Forward Curve Structure $105 $100 $95 USD per Barrel $90 $85 $80 $75 $70 $65 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Forward Months Jun 1, 09 Jun 1, 10 Dec 1, 09 Jan 11, 11 Jun 10, 11 15
MITIGATING CONTANGO & CAD/USD HAS LED TO HUC OUTPERFORMANCE Since the launch of HUC, performance of HUC is + 14% and performance of CAD-denominated USO is 16%, an outperformance of 30% Performance of USD-denominated USO is +1% Therefore 57% of the total outperformance is attributable to the currency effect, 43% is attributable to the contango mitigation HUC versus CAD USO Jun 2009 - June 16, 2011 June 25, 2009 Index = 100 150 140 130 120 110 100 90 Jun 2009 - June 16, 2011 Returns : HUC : +14% USO CAD : - 16% USO USD : + 1% - 57% of HUC outperformance based on currency component, 43% on muted contango - spot WTI contract in USD + 38%, in CAD - 2% 80 70 25-Jun 25-Jul 25-Aug 25-Sep 25-Oct 25-Nov 25-Dec 25-Jan 25-Feb 25-Mar 25-Apr 25-May 25-Jun 25-Jul 25-Aug 25-Sep 25-Oct 25-Nov 25-Dec 25-Jan 25-Feb 25-Mar 25-Apr 25-May HUC CAD USO USD USO Source: Bloomberg, B of C 16
MITIGATING CONTANGO & CAD/USD HAS LED TO HUN OUTPERFORMANCE Since the launch of HUN, performance of HUN is 48.0%, and performance of CAD-denominated UNG is 66.1%, an outperformance of 18.1% Performance of USD-denominated UNG is -58.6% Therefore 45% of the total outperformance is attributable to the currency effect, 55% is attributable to the contango mitigation HUN vs. CAD UNG vs. USD UNG June 2009 - June 16, 2011 June 25, 2009 Index = 100 110 100 90 80 70 60 50 40 Jun 2009 - June 16, 2011 Returns : HUN : - 52% UNG CAD : - 67% UNG USD : - 61% 40% of HUN outperformance based on currency component, 60% on muted contango 30 20 25-Jun 25-Jul 25-Aug 25-Sep 25-Oct 25-Nov 25-Dec 25-Jan 25-Feb 25-Mar 25-Apr 25-May 25-Jun 25-Jul 25-Aug 25-Sep 25-Oct 25-Nov 25-Dec 25-Jan 25-Feb 25-Mar 25-Apr 25-May HUN CAD UNG HUN USD Source: Bloomberg, B of C 17
LIQUIDITY: ETF VOLUME/UNITS OUTSTANDING IS NOT A TRUE MEASURE OF ETF LIQUIDITY! HUC and HUN were designed specifically to minimize the effect of contango while maximizing liquidity Bid/offer quoted by HUC/HUN market-makers is driven by the bid/offer on the underlying futures contract that the market-makers will use in automated fashion to hedge their ETF transaction with you NYMEX WTI December contracts underlying HUC represent the greatest liquidity on the strip (outside of nearby contract months) $10 million tranche involves approximately 100 NYMEX futures contracts Price impact of executing 100 Dec contracts during trading day typically less than $0.15 per bbl, or about 0.15% Similar driver on the NYMEX NG January contracts underlying HUN 18
Concluding Comments Energy ETF investors have served to reduce price volatility rather than exacerbate price volatility Contango cost effect is unavoidable in the energy markets, although some ETFs are structured better than others in terms of managing this effect Contango/backwardation not an issue for short-term hold positions Important issue for longer-term buy-and-hold strategies 19
Commodity Exchange Traded Funds Tim Simard