The ETF Edge in a Falling Oil Market

It's been a challenging year for crude oil, yet investors holding oil-focused Exchange Traded Funds (ETFs) have experienced a far softer landing than the physical commodity itself. This disconnect is due to a favorable structural phenomenon within the futures market.

The US benchmark, West Texas Intermediate (WTI) crude, commenced the year trading near $72 per barrel. After briefly testing the $80 mark in January, it declined sharply, hitting a low of $57 in May and ending the year near that lower band. This resulted in an 18.8% annual loss for WTI, slightly outpacing the 17% decline observed in Brent crude, the main European marker.

In stark contrast, funds designed to track these prices, such as the United States Oil Fund (USO) and the United States Brent Oil Fund (BNO), registered much smaller declines of just 7.7% and 4.6%, respectively.

These ETFs function by holding and periodically refreshing positions in near-month futures contracts. Because these contracts have monthly expiration dates, the funds must continuously transition, or "roll," their holdings into the subsequent month's contract. The performance impact of this necessary process hinges entirely on the prevailing structure of the futures curve.

The Dynamics of Roll Yield

When the nearest contract expires, if the fund is required to sell it and purchase the next month's contract at a lower price—a market structure known as backwardation—it essentially generates a profit by selling high and buying low. This mechanism provides a sustained performance boost, or "tailwind," for the ETF.

Conversely, if the fund must roll into a higher priced contract—a situation called contango—it sells low and buys high, leading to a constant performance drag that compounds over time.

For most of the past year, the oil futures curve has been predominantly in backwardation. This pivotal dynamic significantly augmented the relative returns of USO and BNO, effectively insulating investors from the full severity of the spot price decline. Global geopolitical tensions—including the influence of OPEC+ supply management and Russian sanctions, alongside regional shipping route disruptions—maintained a high premium for prompt delivery of physical barrels, sustaining the backwardated environment.

Changing Market Winds Ahead

However, the underlying market fundamentals are beginning to shift.

Global oil supplies are currently robust. The International Energy Agency (IEA) estimated a substantial increase in world oil supply of $$6.2$$ million barrels per day between January and November. Looking into the new year, the IEA projects an additional production rise of $$2.5$$ million barrels per day, while demand growth is forecasted to be under $$1$$ million barrels per day.

This burgeoning supply is leading to inventory builds, alleviating fears of immediate shortages and placing durable downward pressure on crude prices.

While the front end of the futures curve still exhibits backwardation, it is noticeably narrowing. Further out on the curve, the structure is already reverting to contango.

Backwardation's Historical Edge

The benefits of backwardation have been extraordinary for oil ETFs over the longer term. Over the last five years, USO and BNO have soared by 117% and 128%, respectively, while the underlying front-month WTI and Brent futures saw gains of only 24.5% and 23.3%. This substantial performance differential is overwhelmingly attributable to a prolonged period of favorable roll yields.

Should the curve fundamentally flip and settle into contango, the performance tailwind will rapidly become a strong headwind. Given the global supply outlook, this structural risk is a significant factor as we approach 2026.

ETF investors are currently still enjoying the benefits of positive roll yield. Nevertheless, it is the future shape of the futures curve—more so than the immediate direction of the oil price—that will ultimately govern forthcoming returns.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. Market conditions can change rapidly during a shutdown. Always verify information independently and consult a licensed financial advisor before making investment decisions