UBS' contango ETracs linked to oil or gas futures offer bet on futures curve, contango hedge

By Emma Trincal

New York, June 16 - UBS AG, London Branch priced two new exchange-traded notes designed to offset the negative impact of contango risk in the oil and natural gas markets, the bank announced on Thursday.

UBS priced $10 million of 0% Oil Futures Contango exchange-traded access securities due June 14, 2041 linked to the ISE Oil Futures Spread index, according to a 424B2 filing with the Securities and Exchange Commission.

Additionally, UBS priced $10 million of 0% Natural Gas Futures Contango ETracs due June 14, 2041 linked to the ISE Natural Gas Futures Spread index.

"This is designed to make money in contango markets," a market participant said. "It's not an ETN on oil or gas. It's a pure alpha play."

The ISE Oil Futures Spread index and the ISE Natural Gas Futures Spread index are "brand news indices," he said.

The two separate indexes through a series of investments in either oil sub-indexes or natural gas sub-indexes - depending on the ETN - effectively provide short exposure to the front-month futures contracts and long exposure to far-term futures contracts, according to the prospectus.

UBS said the notes are designed to capitalize on contango in the oil or natural gas futures market while minimizing the exposure to absolute changes in the underlying prices of the commodities.

The contango problem

A market is in contango when distant future contracts cost more than nearby contracts, creating what is known as a negative roll yield.

Notes linked to commodity indexes are subject to contango risk because the index methodology often calls for rolling a short-dated contract (or selling it) into a longer-dated one (or buying it) because there is no delivery.

When the longer-dated prices are above the price of the short-term contracts, the cost of rolling increases, leading to an upward sloping futures curve that creates a negative roll yield. This rolling cost erodes the overall performance of the index, which has a negative impact on investors' returns.

The opposite phenomenon is called backwardation. When a market is in backwardation, the roll yield is positive, which enhances returns.

"By taking long positions on the long part of the curve and shorting the short end, you actually capitalize on contango," the market participant said.

"This really gives you a way to play on the term structure of the curve. It's not a directional bet on oil or gas. It's a bet on the shape of the curve. If the curve is in contango, you're going to make money. If the market reverts to backwardation, then the notes would go down.

"It's no different from buying an oil ETN and betting on the price appreciation of oil. Except that your bet here is on contango, not the underlying commodity."

Original concept

The inspiration for the notes may have come from another ETracs UBS launched six month ago, the market participant. Instead of hedging the term structure of commodities, this prior product is an equity hedge on the term structure of volatility. But both ETNs share some characteristics, he said.

In December, UBS AG, Jersey Branch launched its S&P 500 VIX Futures Term-Structure Index Excess Return ETN, which trades on NYSE Arca under the ticker symbol "XVIX."

The underlying index is a composite index that measures the return from taking a long position in the S&P 500 VIX Mid-Term Futures Index Excess Return with a 100% weight and taking a short position in the S&P 500 VIX Short-Term Futures Index Excess Return with a 50% weight. The weights of the long and short positions are rebalanced daily.

"People really liked the play on the volatility curve, and they thought that the same should be done with futures," the market participant said.

With both the XVIX ETNs and the new Contango ETracs, the long and short exposures embedded in the underlying indexes do not reflect a pure one-to-one ratio.

Long/short ratio

The ISE Oil Futures Spread index, as well as its natural gas counterpart, provides a long-to-short ratio of 1.5 to one.

The index gives investors a one-time short exposure in front-month oil futures contracts and a 1.5 times long exposure in mid-term futures contracts, according to the prospectus.

The market participant explained the reason behind this ratio, saying that it was designed to eliminate exposure to volatility.

"It's 1.5 times versus one because volatility is greater on different parts of the futures curve. If you had one on one, the volatility move would give you a lot of directional exposure to the volatility," the market participant said.

"The short end of the curve moves more than the long end. So you had to reverse the exposure on the longer end in order to hedge out the volatility."

Not so fast

Financial advisers are often looking for commodity-linked notes that can alleviate the impact of contango. The question is how, said Steve Doucette, financial adviser at Proctor Financial.

"You obviously have to do your due diligence about the underlying index," he said.

"My main questions would be: Is it a cheaper way to hedge contango than doing it with options or with another index?

"And secondly, what happens if the market goes the other way and if contango reverts? You'd have to get out of this one. It's going to work against you."

Doucette added that advisers and investors would have to decide how the ETNs may fit into their portfolios and whether the investment should be part of a commodity allocation.

"I don't think I would spend the time researching the answers to those questions because when I invest in commodities, I want a broad-based index," he said.

"Any time you're taking a bet on a single commodity, you're speculating."

Liquidity provider

A futures trader welcomed the new product for its liquidity.

"Whether hedging contango risk would work for investors in the notes is one thing," said Michael Rose, director of trading at Angus Jackson, a commodities and futures brokerage firm. But the new product is good news for traders and the market in general because it will provide liquidity.

Rose expressed some doubts about the strategy, stressing that the market is not necessarily in contango by default.

"They're shorting the nearby and buying the longer-dated. That makes sense. It's a way to reduce contango, but it may exacerbate the opposite if there is no contango.

"We all have the assumption that contango is the natural state, but it's not. It's just that we have all these premiums built in because of the war and the possibility of a huge market disruption.

"But if the market becomes more normal, these types of strategies may exacerbate the problem."

For investors who are betting that contango will continue to be the norm though, the ETNs "may certainly be the solution," he said.

"If you have energy positions in your portfolio whether you're trading futures, ETFs or the physicals, this gives you a new tool without having to go in and liquidate or hedge your position. It's an alternative form of hedging in a way," he said.

"You can put this on in a moment without having to interfere with your existing position and you get a hedge."

Rose said that "whether it will work as a strategy, I cannot tell. But the liquidity will help."

"The fact that these ETNs are coming up will be beneficial to all markets. As a trader, I think that anything that adds to liquidity is a good thing."

The added liquidity will not only come from the new liquid instruments that trade on the exchange, he said. It will also result from the fact that the two new vehicles express a contrarian view.

"Most people know how to get long the front month. This does the opposite, selling the front month and buying those back months. It's the opposite of the way investors tend to think; they tend to think you've got to own it first," he said.

"The liquidity this is going to add to the marketplace will benefit everyone."

The notes began trading Thursday on NYSE Arca under the symbol "OILZ" for the Oil Futures Contango ETracs and "GASZ" for the Natural Gas Futures Contango ETracs.

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