What Are Commodity Oil ETFs?
A commodity oil ETF is an exchange-traded fund (ETF) that offers investors exposure to oil or natural gas as a commodity. Commodity oil ETFs invest in oil futures or natural gas futures. Their performance is linked to the price of oil or natural gas, and they often have significant tracking error relative to the spot price. Their risk and return characteristics are different from equity oil ETFs, which hold equities of companies in the energy industry. We discuss fossil fuel industry ETFs in more detail in a companion note.
Commodity ETFs are also different from equity ETFs in their legal structure. Commodity ETFs are structured as commodity pools and are regulated by the Commodities Futures Exchange Commission (CFTC). Investors in these pools are limited partners and receive a K-1 form for tax purposes. Investors should be aware of these tax implications before investing in commodity ETFs.
Equity ETFs are structured as open-end funds organized under the Investment Act of 1940. They are regulated by the Securities and Exchange Commission (SEC) They are largely limited to holding stocks and bonds. They are pass-through structures, where the income and capital gains flow through to investors; they are not taxed at the fund level. Investors receive a 1099 form for tax purposes.
Investing in Oil and Gas Futures via ETFs
Commodity ETFs provide direct exposure to oil and natural gas futures. The flagship securities (in market cap terms) are USO for oil and UNG for natural gas. There are several other products available that pursue varying strategies, as summarized in Table 1 Appendix A provides additional detail and includes leveraged products that use derivatives to create enhanced (or inverse) returns. Leveraged products have risk/return characteristics that are quite different from the underlying oil and gas futures. We focus here on ETFs that only hold futures contracts.
Most of these ETFs are structured as commodity pools. OILK is structured as an open-ended fund; GAZ is an exchange traded note issued by a bank.
Commodity ETFs Hold Futures – But Are Not Futures Contracts!
The basic strategy for these products is to hold futures contracts and roll them into new contracts as they mature. When the futures curve is flat, i.e., there is little difference between the front and back months, these products track the underlying front month contract and spot price closely. But when the futures curve is upward sloping (contango) or downward sloping (backwardation), tracking error becomes a problem.
When the market is in contango, funds that only invest in the front month (e.g., BNO and UNG) lose money when they roll into new contracts. For example, they receive $100 on liquidating a contract, and pay $101 to buy the new front month contract, which then rolls down the curve and is worth $100 at maturity. Likewise, when the futures market is in backwardation, these funds can score capital gains on the roll.
To mitigate these effects several commodity, ETFs hold a mix of front and back month futures contracts.
Tracking Error Can Be Large
These complexities stand out in sharp relief when we compare the performance of ETFs holding West Texas Intermediate (WTI) futures with the front month West Texas Intermediate (WTI) futures contract (Chart 1). Since 2015, the front month futures contract has varied widely, from a high of $123.70 (8 March 2022) to a shocking low of negative $37.63 (20 April 2020). On that day, the difference between the first and second month was $58.08. In the weeks around then, the difference was about $5-6. Contrast that with a ‘normal’ difference of $0.25-0.50, or well under a dollar. The futures curve in turn has varied from severe contango to severe backwardation over time.
The bottom line is that none of the ETFs came close to matching the price performance of the WTI future. The USO and OILK products in particular suffered huge losses in April 2020 due to the massive contango market.
After the oil futures market settled down by June 2020, most ETFs closely tracked the WTI future, even outperforming recently because the market has been in sharp backwardation since the Russian invasion of Ukraine (Chart 2). Only OILK has lagged due to a difficult roll in December 2021.
A more detailed analysis of why these products did not track the WTI oil future at various times is beyond our scope. Suffice to say, these ETFs are not buy-and-hold products. Over time, their structural quirks will cause their performance to vary from the underlying futures contract, and more likely, underperform. Investors in these products should have a clear understanding of these risks, and of their investment objectives.
Brent Futures Outperform WTI Futures
BNO holds front month Brent futures so is exposed to contango markets. BNO outperformed the USO between 2015 and early 2020 by about 70% because Brent futures were less prone to contango markets than WTI futures. But it still underperformed the front month Brent futures by 22% due to contango exposure. Since June 2020, BNO tracked the Brent front month futures closely and has outperformed recently because the market is in backwardation.
Natural Gas ETFs Have Similar Quirks
Natural gas ETFs track US natural gas prices. They have also tended to lag the front month futures contract over time (Chart 5) due to contango market conditions from time to time. The period since June 2020 has been challenging too – because of a spike in the natural gas future in October 2020 that the ETFs missed (Chart 6). If we rebase the price as of late October 2020, the ETFs track the futures closely.
Commodity ETFs Are Not Buy-and Hold Investments!
We understand the appeal of commodity oil and natural gas ETFs. They offer easy exposure to commodities markets without the technical and administrative intricacies of investing in futures directly. But, as we have illustrated, these ETFs have periods of significant tracking error, especially if investors are trying to capture the headline front month contract performance.
We are not recommending any particular ETF. Rather we strongly suggest investors clearly understand the risk return characteristics of each available product, and select the one that best meets their objectives.
Appendix A: Summary of Commodity Oil ETFs and Natural Gas ETFs
 Strictly speaking, the term ‘ETF’ refers to structures described in this paragraph. However, it often used generically to describe a broad range of securities that trade on stock exchanges where investment performance depends on some underlying. It could be a portfolio of equities that meet some defined criteria, such as companies in the energy sector of the S&P 500; or the price of gold; or oil futures. This broader range of products is also referred to as exchange trade products (ETP). Under this umbrella, there a variety of different legal structures that have differing risk and tax features. More information is available here and here.
 Chart 1 does not show this low as it is weekly rather than daily data.