Sub-zero oil prices threaten big losses for ETF investors
Investors who have flooded into the oil markets to bet on a rebound in crude prices are risking big losses, say commodity specialists, as the exchange traded funds they use are swept up in the current market turmoil.
The United States Oil fund, the largest oil ETF known as USO, saw inflows of about $1.5bn last week, as US crude prices hit their lowest levels since the early 2000s on plunging demand. Professional traders said retail investors, in particular, were trying to pick the turning point for oil, betting that the market will recover quickly once coronavirus-fighting measures are eased.
But prices had further to fall. On Monday, West Texas Intermediate, the US benchmark, crashed below zero for the first time in history, dropping as low as minus $40 as traders dumped the contract for delivery in May. The June contract, where most of USO’s investments sit, lost 15 per cent to about $21 a barrel.
Investors are not just at risk of placing a wrong-way bet, traders say, as oil contracts do not trade like equities. Instead, they expire monthly so the underlying crude can be delivered to buyers — something specialists fear could be poorly understood by greenhorn investors.
“Investment in ETFs currently harbours high risks to investors who might be tempted to passively invest in oil due to ultra-low prices,” said Michel Salden, head of commodities at Vontobel Asset Management. Losses can occur when tracker funds have to “roll” their exposure when contracts expire, Mr Salden said.
If the oil market structure shifts into “contango” — an industry term for when spot prices are trading below contracts for future delivery — then an ETF might have to sell its contracts at the lower price, then buy the next month’s contract at a higher price just to maintain its holdings.
Ole Hansen, Saxo Bank’s head of commodity strategy, said that the largest long-only oil ETFs had seen their net holdings rise by 400 per cent in the past month. These ETFs, he warned, “are predominantly positioned at the front of the futures curve and will be exposed to rolling losses every month until the market fundamentals eventually stabilise”.
That process “could take several months”, he added.
USO was the fourth most actively traded ETF in the US on Monday morning, with more than half a billion dollars changing hands before lunchtime in New York, as the WTI spot price plummeted.
Investors’ move into USO is reminiscent of 2009, when many investors bought the ETF as crude prices slipped to near $30 a barrel, before almost tripling over the next 12 months as the world economy emerged from the depths of the financial crisis. Investors found their ETF returns did not match the oil-price gains, as they had lost a large chunk of their investment each month through the process of rolling contracts.
The USO fund, launched in 2006, typically absorbs cash from investors when crude prices hit bottom. Inflows previously peaked in early 2009 and in early 2016, just after oil-price crashes. Since March, the number of shares outstanding in the fund has doubled as new cash comes in.
As of Friday, the fund held the equivalent of 146.5m barrels of WTI crude futures for June delivery on the New York Mercantile Exchange, a division of CME Group. That was more than a quarter of the total open interest in the contract, exchange data showed.
Nymex market rules impose “accountability levels” of 10m barrels equivalent for most US crude futures contracts, above which traders can be ordered to reduce their position. CME declined to comment on whether it had communicated with USO.
The US Commodity Futures Trading Commission, a government regulator, has proposed a 6m-barrel limit on individual fund positions in US crude on the brink of delivery, but refrained from setting caps for positions in contracts for delivery later on.
Some traders say the USO fund is big enough to exacerbate price moves between different contract months as it rolls out of one position and into another. “That definitely can put downward pressure on the market,” said Joe Raia, a former senior executive in energy futures at Nymex and Goldman Sachs.
USO announced last Thursday that it was moving 20 per cent of the WTI contracts it holds into later months, in a move widely believed to have been influenced by the blowout in the spread between crude prices.
The position “just got to the size where it makes sense to spread it out”, said John Love, chief executive of US Commodity Funds, which runs the USO fund, on Friday.
The USO next rolls its contracts on May 5 to May 8. The fund extended that process to four days early last decade to make it harder for other traders to front-run its moves.
Additional reporting by Gregory Meyer in New York