Oil Plays: Short and Long-Term Oil Trades
by Alfred Lee, CFA, DMS, Vice President & Investment Strategist, BMO ETFs & Global Structured Investments
BMO Asset Management
alfred.lee[at]bmo.com
March 2, 2011
Recent Developments:
- Market concerns of upheaval in the Middle East have led the price of Brent crude to rise given the fear that any revolts may cause disruptions in supply. While the more commonly quoted West Texas Intermediate (WTI) has also gained, a wide spread remains between the two types of oil contracts.
- The current spread between WTI and Brent crude is in excess of three standard deviations from its normalized mean spread. (Chart A) Thus in a mathematical sense, a difference between these contracts or more occurs just 0.5% of the time.
Potential Investment Opportunity:
- Oil tends to be recognized as a “risky-asset” having a tendency to rise and fall with equity market confidence. Its recent surge is due to concerns of political uncertainty in the Middle East choking off crude supplies. Most recently, both Brent crude and WTI gains have outpaced those of oil related equities. In addition, since crude prices began surging on February 22, larger cap oil companies have appreciated, while the smaller-cap oil names have lagged. As demonstrated below in Chart B, there is a correlation breakdown between the larger cap NYSE Arca Oil Index and the Dow Jones North American Select Junior Oil Index. The differential between the large-cap and small-cap indices is partially a result of the market’s recognition that the small-cap names are higher beta names and clearly more akin to "risky assets." Therefore, larger-cap names have been driven more by oil-beta whereas small cap oil names have been driven by market-beta.
- In addition, smaller-cap companies in the Dow Jones North American Select Junior Oil Index tend to be locally involved businesses and as such produce lighter and sweeter North American style WTI crude. Brent crude prices on the other hand are more reflective of Middle Eastern, European and African production and larger-cap oil companies tend to have global operations. With WTI recently gaining, it will be interesting to see whether market-beta or the WTI will be more of a factor in driving the price of small-cap oil companies.
- While civil unrest in the Middle East may not be resolved overnight, both Brent crude and WTI will likely outperform oil related companies for the time being. Investors looking for a short-term trade may want to consider futures-based exchange-traded funds (ETFs), such as the BMO Energy Commodity Index ETF (ZCE) which incorporates a "smart-roll" feature to mitigate some of the contango related concerns. For investors looking further out, we believe the gap between WTI and Brent crude will eventually narrow, particularly because Saudi Arabia has promised to produce any shortfall in supply. When market risk eventually comes off the table, small-cap oil companies will likely outperform large caps, as we anticipate junior oil companies to continue to price in increased merger and acquisition activity. We therefore think longer term investors should consider the BMO Junior Oil Index ETF (ZJO) and suggest investors look to both the S&P/CBOE Implied Volatility Index (VIX) and CBOE Oil Implied Volatility (Oil VIX) Indicators for appropriate entry points. See Chart C for the recent performance comparison of the two ETFs mentioned in relation to near month ICE Brent Crude.
Chart A: Brent-WTI Crude Spread of This or More is Extremely Rare Occurrence
Source: Bloomberg, BMO Asset Management Inc.
Chart B: Small Cap and Large Cap Oil Correlation Breakdown
Source: Bloomberg, BMO Asset Management Inc.
Chart C: ZJO and ZCE vs. Near Month ICE Brent Crude
Source: Bloomberg, BMO Asset Management Inc.
*All prices as of market close March 1, 2010 unless otherwise indicated.
Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.
BMO ETFs are managed by BMO Asset Management Inc, an investment counsel firm and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.
