Given the quality of yesterday’s developments the oil market did well to retreat only as much as it did. The two major crude oil contracts fell 67 cents/bbl (WTI) and 88 cents/bbl (Brent) respectively. Winter in North America helped the CME Heating Oil contract, which was one pillar of support, remain resilient. Despite continuously rising Omicron cases European governments have taken the view that the time is now right to ease restrictions raising the hopes of oil demand recovery.
Without these developments the oil market should have ended the day much lower. Last week’s rise in geopolitical risk premium seems to be abating as the situation in Kazakhstan is normalizing and output at the Tengiz oil field is gradually rising again. Production has reportedly restarted at Libya’s Sharara and El Feel oil fields after output dropped from over 1 mbpd to just above 700,000 bpd. The cut in next month’s Saudi and Kuwaiti official selling prices to Asia also suggests that there will be no shortage of crude oil in the coming month. So, do all of the above mean that the top has been found and now focus will shift to the perceived excess supply in the first quarter of the year? It is plausible, however, cold winter, lack of progress in the US-Russia talks over Ukraine and frisky natural gas could keep oil prices volatile before these ominous signs disappear and bulls slowly edge towards the exit in coming weeks.
The underappreciated RBOB contract
Commodity and equity funds, money managers and financial investors, in general had a stellar year in 2021. Risky assets produced eye-catching returns for well-publicized reasons. Both the supply and the demand side of the equation proved supportive. Assorted stimuli, both fiscal and monetary, have successfully stimulated aggregate demand. Supply chain bottlenecks triggered by the flare ups in infections in different parts of the world led to the “shortage of everything” pushing consumer and producer prices even higher. Quarterly financial corporate results were more than attractive, the tech sector provided invaluable support to the Nasdaq index and the banking sector enjoyed one of its best years greatly aided by mergers and acquisitions as consolidation became the magic word in several segments of the global economy. The MSCI Global Equity Index returned 17% over 2021 and if you had spent $1 on the S&P 500 index at the very end of 2020 you would have been 27 cents richer by exactly a year later.
The commodity sector also enjoyed rising prices due to central helps from governments and reserve banks. Cheap money led to rising demand for raw materials as the world crawled out of the virus-induced destruction and the bullish backdrop was magnified by global supply constraints. The Refinitv/CoreCommodity CRB index returned 38% over last year and the S&P GSCI Commodity Index (Total Return) strengthened 40%.
Oil was affected by the same forces and the influence and the successful market management policy of the OPEC+ producer group made it the standout category within the investment fraternity. The S&P GSCI (Total Return) energy sub-index ended 2021 61% up and the US Oil Fund returned 65% to investors. Amongst the five main oil futures contracts traded on the CME and ICE the annual results were all positive; they ranged from 50% (Brent) to 59% (RBOB) on a front-month basis.
The annual performances, of course, are much better when monthly roll-overs are taken into consideration. (We arbitrarily assumed that length was always carried from one month to the next on the first trading session of each calendar month, albeit commodity indexes use several days for this procedure.) With the exception of ICE Gasoil every contract was in backwardation throughout last year. With monthly roll-overs taken into account the worst performer would have been ICE Gasoil with 58% whilst the CME RBOB contract would have come out on top as it would have returned slightly more than 73 cents on the dollar.
Which leads us to an interesting observation. RBOB’s performance last year is not a one-off, it did not happen accidentally. When one compares the returns of the five futures contracts over the past 15 years it has been the jewel of the oil crown more than half of the time and has hardly ever been the worst performer. Yet, its role in a commodity or oil basket is underrated. This “negligence” is the result of the philosophy behind the construction of any commodity index. Let us take the S&P 500 GSCI commodity index as an example. Its weighting, which is re-balanced every year, is determined by the physical production of its components.
Whilst it is hard to argue against such logic, maybe it is worth trying. After all, over the past 15 years the two main oil futures markets have experienced an explosion in volumes because of the introduction of electronic trading. Consequently, outright prices are determined by financial supply-demand, which does not necessarily reflect the physical backdrop of the underlying commodity. The latter is better mirrored in the structure of the individual futures contracts. For this reason, one might conclude that the weighting of a commodity index that is based on physical production is somewhat outdated, and the performance could be enhanced by using futures volume (financial supply and demand) together with price volatility when composing the basket. This approach would inevitably put more emphasis on RBOB.
The latest composition of the S&P GSCI and the Refinitv/CoreCommodity CRB indices shows that RBOB’s weight to WTI is around 1 to 5. At the same time the CME RBOB contract, more often than not, outperforms the energy sub-indexes of commodity indexes or the US Oil Fund. Historical data suggests that putting more weight on RBOB will result in improved returns – unless, of course, one takes the view that the transition from fossil fuel to renewables and the growing popularity of electric vehicles will put this product in investors’ bad books soon, something that does not seem imminent.