How Do Oil Participation Certificates Work?
The functioning of 1:1 participation certificates on the oil price is very similar to the functioning of other participation certificates, eg on stock indices. Theoretically, a 1:1 participation certificate should reflect the oil price 1:1, but investors should note one important point: the underlying assets of oil certificates are (WTI or Brent oil) futures and these futures traded on the futures exchanges must be redeemed due to the expiry date of certificate issuers are rolled over and over again. In this context, rolled means first of all that the future must be sold shortly before the end of the term in order not to risk physical settlement.
Hardly any issuer of a certificate on oil is likely to be interested in physical settlement. Furthermore, the money collected is to be invested in the next future in order to continue to participate in the oil price. However, since oil futures that are more distant in time are usually quoted higher than the old future, there are often rolling losses for the investor. In professional circles, this situation contango called. This can even lead to the certificate not increasing in price despite a rising oil price, because the rolling losses eat up the profits.
This leads to the rather unusual situation that more distant futures are quoted lower in price than contracts that expire earlier. This saves money when rolling, which should benefit the certificate investor. A backwardation situation could arise, for example, if an important shipping route is suddenly made impassable for oil tankers (eg military naval blockade of the Strait of Hormuz in the Persian Gulf) and current oil demand exceeds current oil supply. Then the price of the oil future that is closest in time could be (significantly) higher than oil futures that are further away, since many market participants now want to secure oil immediately, until there is perhaps no longer enough oil available or prices continue to rise and oil is becoming more and more expensive.