UBS creates structured commodity note

In a research note to investors last May, UBS fixed income analyst Tony Morris pointed out the benefits of shifting investment in the oil markets away from the front end of the forward price curve to the back end.

This note generated investor demand for a new product, which would give exposure to the long-dated oil curve and eliminate some of the problems associated with traditional commodity-index products that invest in the front of the price curve.

In response to this demand, Kathy Kriskey (née Brady), head of the UBS commodity investor team, developed an innovative and flexible product called the UBS Oilfield Strategy Index.

"The index attempts to mirror the exposure an oil producer has to oil prices," explains Kriskey. "The longer-term exposure means there is less volatility, but still the benefit of returns."

The back-end of the curve is deemed attractive not only because it is much less volatile than the front months, but also because it has outperformed the front in recent months (as shown in the accompanying graph). The combination of lower volatility and high returns results in an increased Sharpe Ratio, when comparing the Oilfield Strategy Index to other commodity indices. Additionally, because the front end of the curve is now in contango (meaning the front month is cheaper than the following month) there is a cost associated with moving out of the front month into the next contract, something that has to be done every month with traditional indices like the Goldman Sachs Commodities Index or the Dow Jones-AIG.

In a backwardated market, this 'rolling' of futures contracts has previously brought in a premium. More recently, however, the contango has led to severe roll costs – so much so that at one point, while the underlying commodities were up 15% for the year, the index return was down 2.76%.

"Everyone's tried to solve the problem of the negative-roll yield," comments Kriskey. "But other attempts only went out so far. Our Oilfield Index has gone much further out along the curve." This new index references West Texas Intermediate (WTI) crude futures out five years.

However, solving the negative-roll yield shouldn't be the sole reason for using this product, Kriskey stresses. "It is also an investment in the back end of the curve and the belief that it will perform well. Also this is an additional diversification for an investor in commodities: diversification across time. Given the volatility in the commodity markets, we believe investors will begin to apply what they already know in interest rates to commodities."

One asset manager in particular, Deutsche Asset Management, saw the added value of owning the back of the crude oil price curve as part of their active, diversified approach to commodities investing.

Working with Deutsche Asset Management's managing director, head of global commodities Theresa Gusman, UBS issued a customised structured note substituting the new UBS Oilfield Strategy Index for the oil exposure in the GSCI. Deutsche Asset Management was already benchmarked off the GSCI, and so UBS created one note, referencing all the sub-components of the GSCI, except carving out the crude oil components, which represented 48% of the index at that time, and replacing them with the UBS Oilfield Strategy index. The resulting structure helped to solve the issue of the negative-roll yield.

"This was a unique addition to our portfolio and so far it's worked phenomenally well," says Gusman. "The back end of the curve has not only performed better than the front, but we haven't had to subject our clients to the negative-roll yield."

The notes are for one year and started in September 2006. If the market were to flip back into backwardation at the front end and contango at the back, this index would look less attractive, Kriskey concedes. However, UBS believes this is unlikely to occur any time soon.