As you can see in the following chart, the Invesco DB Energy ETF (DBE) has continued trading higher on the back of strength in the energy commodities.
It is my belief that this trend of recovery in DBE is going to continue. I believe that DBE is supported from both an instrument methodology perspective as well as from a fundamental perspective and that in the coming weeks, DBE is going to continue trading higher.
About the ETF
Put simply, DBE is a fairly complex and confusing instrument. The reason why this is the case is that not only is DBE exposed to several different energy commodities, but also it is using a dynamic allocation strategy to move exposure across the futures curve. Let’s explore the implications of this strategy before jumping into a recommendation regarding the fundamentals.
To start off, DBE is a very broad ETF. In fact, it is the broadest ETF I have ever seen when it comes to gaining exposure to energy. What I mean by this is that within the ETF, you are holding WTI, Brent, gasoline, distillate, and natural gas…all within the same fund.
If you’re familiar with energy commodities, this is potentially problematic because there are several different fundamental messages which impact each of these commodities. In other words, to understand what is happening to DBE comprehensively, you would need to do a full, in-depth dive on every single commodity which goes into the ETF to arrive at a complete recommendation. However, I believe we have a bit of a shortcut to this analysis in that most of the commodities (all but natural gas) are highly correlated with each other.
What this chart shows is that most of DBE’s holdings are actually quite similar at the end of the day. For example, if you understand where gasoline is likely headed, then you will probably understand where Brent is likely headed as well – from a high level perspective as well. This clear correlation allows us to zero in on the key fundamental message of energy in total to arrive at a fairly comprehensive recommendation on the ETP.
And the second facet which makes DBE a fairly complex instrument is that it is shifting exposure according to the DBIQ methodology. This family of methodologies focuses on attempting to maximize the benefits or minimize the detriments of roll yield to long holders of the commodities.
At a high level, when you’re holding exposure to futures contracts, you’re exposed to something called roll yield. Roll yield is what you get when you have on a futures position and your position converges towards the spot price. What this means is that in most markets, there is a small, but material difference between the prices of futures contracts as well as the spot price of the commodity. This difference is known as either contango (if the futures are above the spot) or backwardation (if the futures contracts are below the spot price).
When a market is in contango, roll yield is negative to futures holders. The reason why this is the case is that if you were holding futures contracts priced above the spot market, then as time progressed, you would see a slow loss in value in relation to the spot as your futures contract converged. Conversely, a market in backwardation would see the opposite in that gains would result.
An interesting facet of roll yield is that the greatest impacts tend to occur at the front of the curve. For example, if you’re holding a futures contract which is 1% above the spot price and you have 1 month until expiry, you will likely see that 1% completely evaporate by the end of the month. However, if you were holding a futures contract 1% above the spot price but 3 months from expiry, you would only see a gradual reduction which would accelerate in the last few weeks of the life of the futures contract.
These concepts are what DBIQ uses to shift exposure across the futures curves. When the energy commodities are in backwardation, DBIQ will be moving exposure towards the front of the curve to maximize the benefits of roll yield. Conversely, DBIQ will be moving exposure to the back of the curve to minimize negative roll yield costs when the market is in contango. We could dig into examples; however you can see this process fully at work in the table of holdings with some exposure held all the way towards the middle of 2021.
I believe that DBIQ is a clear win for shareholders. The reason for this is that most of the simplistic ETFs which are tracking energy tend to get hammered through time due to roll yield. For example, the popular crude oil and gasoline ETFs can see upwards of 15% or more of lost value per year simply from roll yield. DBIQ however allows investors the ability to maintain exposure in such a way that roll yield is either completely negligible or actually a benefit to holdings. This is an important facet of trading energy and allows you to capture broad fundamental themes without having to worry about roll yield losses to the same degree of alternative funds.
As mentioned earlier, DBE is complex and doing a complete fundamental analysis on 5 different energy commodities is a very large undertaking. Luckily however, we are seeing the same fundamental picture across the commodities and that is a bullish recovery in price due to weakening production.
For example, over the past few months we have witnessed the largest decline in the history of natural gas production.
This weakness in gas production is almost certainly going to lead to a decline in inventories – a decline which we are already seeing the green shoots of with natural gas stocks growing either at or below the 5-year average for almost every week of the past two months.
Put simply, if we even see a mild increase in demand, gas inventories are likely going to start contracting very quickly leading to higher prices.
This same fundamental thesis is being played out across the major holdings of DBE. Put simply, we are at a bullish turning point in fundamentals in which production is hampered and demand is generally recovering, as seen by the climbing refining runs.
Going forward, we should expect to see this trend of recovery to continue as long as the economy continues recovering as well. And ultimately, until we see higher prices, production will remain weak. This recovering demand will offset the weak production which will almost certainly continue pulling prices higher benefiting DBE.
DBE is a complex instrument which is holding several commodities while using a dynamic rolling methodology. The rolling strategy of DBIQ is a clear win for investors in the ETF due to its ability to shift exposure across futures curves. Energy fundamentals remain bullish as production declines and demand recovers.
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.