What an Oil ETF Has to Do With Plunging Oil Prices

(Bloomberg) -- The oil market is in disarray, a result of a coronavirus-led collapse in demand, surplus supply following a price war and a shortage of storage. Yet there have been plenty of people willing to bet on a rebound in basement-level crude prices, and for many retail investors the vehicle of choice has been an exchange-traded fund. However, those wagers via the biggest American ETF -– the U.S. Oil Fund, or USO -– have contributed to market mayhem and helped push crude prices below zero.

1. What did the fund do?

It grew so huge so quickly that it became a sizable player in the market for West Texas Intermediate, the U.S. benchmark for crude. Investors piled in during March and April, convinced that oil prices that had been falling -- pushed down by a price war between Saudi Arabia and Russia that boosted production just as demand was slashed by pandemic-driven lockdowns -- would eventually recover once economies reopened. At different stages, the fund held about a quarter of all May and June contracts for WTI.

2. What’s the problem?

Unlike shares that can be held as long as an investor chooses, oil futures have finite terms and are agreements to buy or sell a physical product. The May futures contract, for example, expired on April 21. Any holder who had not sold by then would need to take delivery of the oil -- 1,000 U.S. barrels, or 42,000 gallons, for each contract.

3. Where does USO come in?

As a favored investment vehicle for many bullish speculators, the number of shares in the fund ballooned from 145 million at the end of February to more than 1.4 billion by mid-April. Its outsized portion of the WTI market -– on paper -- came at a time when demand for physical oil was cratering and storage space was becoming harder and more expensive to find.

4. What does that have to do with the price plunge?

For years, USO was mandated to invest in the most-active WTI contract and to roll it over to the following contract. (Rolling over means selling it and, often simultaneously, buying the following month’s contract.) The flood of money into May contracts earlier had pushed oil prices up; as USO sold its May futures as part of the rollover and bought June and July contracts, prices fell for May and rose for the following months, opening an unusually wide spread. Only a handful of traders remained in the May contract on Monday, when prices plunged well below zero.

5. What’s the worry now?

With USO holding a significant level of June contracts, there are concerns that prices will go negative again and that the whole process might repeat -- or might be worse, if the April 20th debacle scares off more investors. To try to mitigate the prospect, USO, which lost 37% of its value in the first three weeks of April, has moved to allocate some holdings to contracts expiring later in the year, since those prices tend to be less volatile. But the fund is adding to pressure on oil prices in other ways.

6. How is that?

There was so much demand for USO that it exhausted the number of shares it was allowed to issue and, on April 20, asked regulators for permission to register an additional 4 billion, more than double the existing number. Until the new shares are cleared for issuance, the ETF will not purchase more futures contracts, according to analysts, potentially adding to pressure on crude prices. Without new oil contracts, the fund will also become untethered from the prices it’s supposed to track.

7. Anything else?

ETF prices are kept in sync with the value of their holdings, their so-called NAV (net-asset value), through the creation and redemption of shares. So-called “authorized participants” for instance sell an ETF when it’s rising and buy the underlying security to pocket a quick profit, keeping the fund’s price and NAV in lockstep in the process. However, with the authorized participants no longer able to create shares, that’s disrupted demand for the underlying contracts.

8. How about other ETFs?

USO is hardly the only exchange-traded fund to be hammered by the swings in oil futures; the effects were felt around the globe. The Samsung S&P GSCI Crude Oil ER Futures ETF, whose holdings of the derivatives slumped 26% on Tuesday to $378 million, saw its traded units lose half their value for a time Wednesday. Closing down 46% at HK$1.79, the ETF had its biggest drop and lowest finish since trading began in May 2016. Credit Suisse Group AG told investors in a leveraged exchange-traded note that tracks the price of oil they probably won’t get any money back after the value of the note dropped below zero.

The Reference Shelf

• A QuickTake about the day when oil prices fell below zero.
• How mom-and-pop investors came to pile into USO.
• A Bloomberg Opinion column on the risks of oil ETFs.
• A Bloomberg News article on how negative oil prices are leading some traders to rewrite risk models, and one on how others are betting the lows won’t last.
• A QuickTake on the OPEC price war that flooded markets with oil just as demand cratered.
• Bloomberg Professional subscribers can see oil net ETF positions at {.OILETFNT G Index }.

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