Insider’s view: Oil Prices. What on earth just happened?

Oil just keeps hitting the headlines over and over again and it is almost impossible to miss in the news. It’s not surprising with the way WTI has been priced over this week? But why has it been so volatile?

First the boring bit. What is a futures contract? Futures contracts – including futures contracts for oil – are an agreement to buy or sell a commodity at a future date at a specified price. You can buy a contract that’s as early as one month ahead or as far into the future as a year or beyond.

Futures markets oil contracts require a physical delivery of oil if you are holding that contract on its maturity date. And the majority of traders are not in this too take physical delivery. It left an odd position as we got closer to the maturity date, where holders of contracts had to close out their positions “at any cost” in order to avoid taking the physical delivery. Combined with other factors that lead to a massive sell off and hence a dip all the way into negative territory touching minus $40. Ouch. Although the May contracts eventually matured at $10.01.

No one has ever seen oil go negative before. It simply has never happened. But there are other points now to be taken into consideration. The average trader who doesn’t understand the futures market may well have bought into an Oil ETF without fully understanding what they are buying in to and how they work. And that could have potential dire consequences financially.

The biggest Oil ETF out there is the USO or the United States Oil Fund. This puppy has the biggest lions share of investors with 4.1 billion USD invested and nearly ½ billion USD piling in very recently as oil plummeted in the hope to take advantage. It is designed to track the daily price movements of West Texas Intermediate (“WTI”) light, sweet crude oil. This week alone the USO managers have vaporized billions from unwary investors.

The managers behind the largest oil ETF announced a 1-for-8 reverse stock split yesterday (a compounding of shares to make a smaller amount of more valuable shares), and today the USO – which was briefly halted during trading hours has unveiled a rebalancing of its composition to relieve pressure on the June WTI Futures, (after getting burnt on the May Futures Contracts) and to spread the pain among even more forward months. Specifically, the USO announced that it would reallocate as follows:

• June: 40% down to 20%
• July: 55% down to 50%
• August: 5% up to 20%
• Sept: 0% up to 10%

Why is the USO doing this? To avoid a repeat of the May WTI implosion, and to prevent a crash on May 19 when the June WTI contract expires. Now that we have seen what happens on maturity day, when on Monday the maturity of the May contract sparked a liquidation wave as nobody wanted to take delivery, traders were preparing to frontrun the USO getting delivery next month by shorting the hell out of the June contract. And since, it is all so very circular, by removing selling pressure on the front contract, the USO may fight to live another day.

That was not all, however, because separately the USO also announced it may “also invest in other oil-related investments such as cash-settled options on Oil Futures Contracts, forward contracts for oil, cleared swap contracts and non-exchange traded OTC transactions that are based on the price of oil, other petroleum-based fuels, Oil Futures Contracts and indexes based on the foregoing”

And while we admire the USCF’s efforts to keep the USO Fund alive, what would be very bad is if all 3 or now 4 WTI futures in which it has positions, were to turn negative. That’s when the USO would have no choice but to finally fold. And investors lose their shirts.

So let’s explain it a bit better.

1. Its paper trading, not physical oil

The U.S. Oil Fund’s objective is to track the daily price movements of West Texas Intermediate (WTI), which is the primary U.S. oil benchmark. It does this by purchasing oil futures contracts that expire over the next few months. While these contracts require the holder to take physical delivery of the oil upon expiration, the U.S. Oil Fund doesn’t want to own physical crude. Because of that, it rolls these contracts before they expire.

That creates some frictional trading costs. Those expenses can be quite steep, especially when the oil market is in contango, which means futures contracts a few months out trade at a higher price than those expiring in the near term.

2. Expect underperformance, especially over the long term

The expenses that the U.S. Oil Fund racks up to roll its futures contracts add up over time. On top of that, it charges holders a 0.45% management fee. Those costs have weighed on the fund over the long term. That’s evident in the ETF’s performance relative to WTI over the years:

Since most traders buy oil price ETFs like USO for the express purpose of speculating on short-term price movements, they’re likely not all that concerned about the long-term underperformance. If oil rallies sharply in the near term, the trade should make money.

But speculators often get one thing wrong: timing. While they could be correct in the view that oil will rally, that might not happen as quickly as expected. Because of that, they might need to hold their oil price ETF for several months. In doing so, they run the risk of contango and other costs eating into their returns and wiping away most of the profit (if not all of it) from an eventual rebound in crude prices.

3. Oil ETFs might not survive the recent oil rout

Interest in speculating in oil price ETFs has surged recently, given all the turmoil in the energy market. Negative oil prices aren’t sustainable, suggesting that prices could spring higher. That’s certainly what the futures market indicates as WTI contracts for later expirations are currently in their $30’s.

However, that doesn’t mean oil ETFs will survive long enough for speculators to profit from higher prices in the future. Barclays, which issues the iPath Series B S&P GSCI Crude Oil Total Return Index ETN, announced that it would stop distributing new shares on Tuesday and redeem the fund at the end of the month.

Meanwhile, trading of the U.S. Oil Fund halted twice on Tuesday due to extreme volatility. That fund also said that it would stop issuing new shares as its value whittled down to zero. This ETF might also end in a forced redemption. But even if it survives, there’s such a wide gap between near-term futures contracts and those that expire in a few months that speculators might lose money (possibly their entire investment) even if oil prices rally sharply in the coming months.
There is one more point. Yesterday, USO froze the creation of new USO units. This is a critical development. The creation and redemption of ETF units is what keeps USO in line with its NAV (Net Asset Value). That is, this is the mechanism which assures that when you buy USO, you’re paying a price that’s similar to what the assets USO holds are worth. It is, literally, what keeps USO attached to the (harsh) realities of what it holds.

So what happens if USO no longer allows the creation of new units? Well, then market players, crazed with desire to own crude through USO exposure, can bid USO well over its NAV without this counter-force impeding USO from detaching from NAV. In short, since USO unit creation is now frozen, USO is free to trade at ever higher, irrational, premiums to NAV. It is free to detach from reality.

You don’t want to be holding that can in the coming months.

Words by Lawrence Young | The opinions expressed here are his own

Lawrence Young, The Author

Lawrence Young (lawrence.young@holbornassets.com) works for Holborn Group, he is now based in Vietnam office. His areas of expertise lie in personal, lump sum or regular monthly premium tax free savings structures, global investment property, higher education fee planning, inheritance tax issues, frozen and open pension planning through ROPS or SIPP’s, life and general insurance, will writing services and offshore company formation and banking.