As you can see in the following chart, the past few weeks have been quite favorable for traders in the Invesco DB Energy ETF (DBE) with shares continuing to push to new highs in the recent trend.
In this piece, I argue that DBE is likely headed higher. I believe that the fundamentals of all of the major commodities underlying DBE are bullish and that investors should maintain long positions to capture the continuing trend.
DBE is a very complex instrument, which means that we’ll need to examine its methodology in depth prior to ending this piece, but let’s start off with an analysis of the energy markets. Put simply, this has been an incredibly dramatic year for energy with prices of energy commodities weakening substantially.
The major driver here is of course the spreading virus. Energy is used in a lot of different ways, but the major swing variable is transportation. When there is a broad-based impact on transportation, energy gets crushed. As you are almost certainly aware, this year witnessed a historic closure of the economy with shelter-in-place orders issued across the country. This resulted in refining demand collapsing because less driving means less demand for gasoline or distillate.
At present, this is the primary fundamental question to answer when it comes to understand the broad movements of the major commodities DBE holds: what will happen to transportation demand throughout the rest of this year?
I believe that the current trend of recovery will continue. I base this belief on the administration clearly stating that it will not allow broad-based closures once again. Political discussion and views aside, if there will be no more broad-based closures, then the baseline expectation for energy demand is that of recovery in that more individuals will be returning to work and therefore more gallons of gasoline and distillate will be needed to satisfy this demand.
We are at a very interesting juncture in the history of energy in that right now all of the major energy holdings of DBE (crude, gasoline, and distillate) are all sharing the same fundamental message: whatever happens to driving demand over the next few months will shape the demand for the entire liquid energy value chain. This has me bullish DBE at this time and looking for further upside in the ETF.
However, if you’ve looked at DBE’s holdings, it is also maintaining exposure in natural gas futures. This is a bit of an odd addition into this ETF in that the fundamentals for natural gas and the liquid petroleum commodities have decoupled to the point where each commodity should be separately studied and traded.
This said, I am bullish natural gas. Put simply, drilling activity is collapsing.
And while demand is weak, it is not unusually so, with the latest demand figures coming in over the five-year average.
Not only is this the case, but also power demand is set to continue forward another record-breaking year due to extremely hot weather across the United States.
In short, natural gas is quite bullish because we’ve reached the point where weak prices have significantly dampened drilling appetite while at the same time demand is poised to strengthen. Simple supply and demand economics indicates that prices are likely to rise (and indeed have been rising over the past few weeks).
I am bullish all of the underlying commodities which comprise DBE based on recovering refining demand and a tightening natural gas supply and demand balance.
DBE is a remarkably complex instrument. In my opinion, it may have bitten off more than any specific instrument can chew. What I mean by this is that not only is DBE holding two types of crude, gasoline, distillate, and natural gas, but it is also using the DBIQ methodology of dynamically shifting exposure to maximize the benefits or minimize the detriments of roll yield.
There’s a lot going on behind the scenes with DBE, so let’s step through it. First off, DBE is holding several different commodities. This wouldn’t necessarily be a big deal except that the basket of holdings is highly correlated. In other words, if you were to hold, say, Brent and gasoline over a year or so, your return between the two commodities would actually be fairly similar. From a numeric perspective, the smallest correlation between all of the petroleum commodities held over the past few years is around 85-90%. In other words, there just isn’t that much of a difference between holdings. The reason why this is potentially a problem is that if you are holding DBE, you may want to question the benefits you gain from investing in this versus a more commodity-focused ETF or ETN which zeroes in on the specific product you want to hold.
So that’s the diversification problem – about 90% of DBE is in commodities which are highly correlated with natural gas (much less correlated) only maintaining 10% of exposure. However, there’s a key benefit to shareholders and that is DBE’s approach to managing roll yield. This is a fairly complex topic, so I’ll try and make it as simple as possible.
In most markets, there’s a difference between the price of a commodity in the spot market and in the futures market. This difference is due to a number of different things such as supply and demand shortfalls or surpluses and can be substantial. The key thing for commodity investors to understand though is that through time, the difference between futures contracts and spot prices erodes to be zero (a process called “convergence”).
In most markets, the futures contract is the side of the relationship which is doing the converging – that is, if futures are priced above the spot level, they tend to fall towards the spot price of the commodity through time. Conversely, if futures are priced below the spot level of the commodity, they tend to increase in value in relation to the spot price of the commodity throughout a typical month.
Convergence between spot and futures is gradual, but most of the change tends to happen in the last few weeks before expiry of a futures contract. What this means is that a futures contract say, 12 months out, will converge at a much slower pace than a futures contract which is a week or two out from expiry (since after expiry, the futures contract is typically converted into the spot commodity).
This last paragraph is exactly why most of the popular commodity ETPs have suffered such dramatic losses when observed through time. Most commodity ETPs tend to hold the front futures contract (because it’s generally the most liquid and reflects the changes in the commodity with the highest degree of correlation) and most energy futures have been in contango most of the time. This means that since these funds are holding futures in the front of the curve and since they are experiencing convergence in a contango market, they are slowly losing value in relation to the spot price.
And here’s where DBE’s methodology shines. DBE will intentionally shift exposure far out along the curve during contango markets (since convergence happens much slower in back-month futures). Conversely, it will shift exposure to the front of the curve during backwardation to capture positive roll yield. Over time, this results in the best option for investors for tackling the tricky topic of roll yield and remains a very strong win for DBE.
Overall, I have mixed views on DBE. I feel that its degree of diversity across energy commodities really isn’t much diversity at all. But at the time it is activity managing exposure to give a benefit to shareholders by either minimizing or maximizing roll yield depending on market structure. Ultimately, I am bullish DBE for the reasons previously mentioned and believe that its methodology will benefit shareholders. However, if you have a more specific view on individual commodities like crude, gasoline, or natural gas, there are more direct ETPs which may be more tailored to your needs.
DBE is headed higher as petroleum demand recovers from the virus and is likely going to continue recovering. Natural gas markets are quite bullish as supply continues to weaken while demand is set to increase. DBE is a fairly complex instrument with several important factors to consider before holding.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.