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Michael Burry, the hedge fund manager who predicted the subprime crisis in The Big Short made headlines last year when he predicted that an ETF bubble was set to implode and he was positioning himself to profit from it. The shoe dropped on ETF volatility and mis-pricing with coronavirus yet most ETF’s have managed to continue to track their underlying indexes relatively well.
The real danger of ETF’s may have become more apparent today in what we witnessed in the West Texas Intermediary or WTI futures market. The day started with the contract for May delivery down from +$18.27 at the start of the day to -$37.63 by the end of the day.
Source: Bloomberg
It’s truly an unprecedented event yet there is an interesting and somewhat complicated story behind this drop that most of the headlines won’t tell you.
For example, why were the Brent crude futures closing at $25.57 a barrel for the same delivery date but WTI going negative?
Brent Prices
Source: barchart.com
Strangely enough, the answer may have something to do with retail ETF investors who were trying to call the bottom of the oil market. Before I get into that and why that is, it probably helps to understand the futures market for oil a little better.
How the Futures Market Works
Unlike buying stocks, the commodities futures market has an underlying good that is backing it is scheduled for delivery. This is important for commodity producers who like to fix a price that they know that they can sell at once they start production. Locking in a future price via a contract is one way they can take away a lot of uncertainty that is involved in volatile commodities prices.
A futures contract is a custom document between seller and buyer, however the Chicago Mercantile Exchange sets a standardized contract with the terms here. WTI is the standard benchmark type of oil traded on the New York Mercantile Exchange (NYMEX). When a contract conforms to these terms, it then is standardized and can be traded on the futures market. In the case of WTI crude, one futures contract represents 1000 barrels of oil and can be traded without delivery up to one month before the scheduled delivery of the barrels. Once you are within that month, you have to arrange for pickup or storage of the oil. The delivery will take place in Cushing Oklahoma, hence the term Cushing WTI. The delivery location can only be there, this is in contrast to Brent crude which can be delivered offshore to a variety of locations.
The original buyer does not have to take the delivery, they can enter into the contract but then sell it to another market participant who may want to speculate on the price of oil. Other market participants may be other commodity producers, storage companies or traders who need to hedge oil positions. Positions are taken with a clearing house between parties to limit payment risk.
Traders also don’t have to pay the full value of the 1,000 barrels that the futures contract represents, they only have to pay a portion and will be subject to margin calls and collateral posting if there are large price swings by the exchange. This introduces leverage into the price, which again, some market participants may find useful.
Another important aspect to note is that in the oil futures market on the NYMEX, the last trading day is the third business day before the 25th calendar day for the month preceding the delivery month. For delivery in May, that day was Monday the 20th.
Traders do not want to take delivery, they want to speculate on prices, so on the last trading day they will need to rid themselves of a long contract by selling it or cover it with a put to avoid taking the delivery. Contracts roll from month to month and when prices in future months are above the current month, traders will lose money as they have to sell their futures at the current cheaper prices and buy the more expensive futures for next month. This is called contango. The opposite is called backwardation, where new contracts are cheaper and buyers get into new contracts with cheaper prices. The oil markets are often in contango and can remain in contango for long periods so buying and rolling of monthly oil futures contracts is usually a losing long term strategy.
The delivery aspect of this is important, this means that the futures price of Cushing WTI is essentially
= Price of a Barrel – Storage Costs
If storage costs exceed the price of a barrel in a particular local market (like around Cushing Oklahoma) in theory you could see the storage cost exceed the value of a barrel and prices for the futures contract go negative.
Enter USO
It is well established that the oil price has taken a massive hit worldwide this year. We saw a demand shock in the form of lockdowns due to coronavirus, combined with a price war between Russia and Saudi Arabia that further plunged prices.
Despite OPEC agreeing to some production cuts, oil has continued to fall. Seeing this, some market participants have been eager to try to time the market and be the first one in when oil hits bottom.
Intuitively it makes sense, oil is vital to the global economy and an important input not just into transportation but to plastics, lubricants, waxes, asphalts etc. There is some inherent value in crude oil as a useful commodity, if the market is quoting very low prices, it makes sense to jump in when prices are at an all time low in real terms.
One way it seems that retail speculators have tried to do this is by investing through an ETF called USO, which stand for the United States Oil fund. Futures contracts tend to converge towards the spot price as the final trading date nears so ETF’s like USO attempt to mimic the spot price for investors by buying 1 month oil futures contracts and then rolling them over each month.
As I described above, if the market is in contango, then this is a losing strategy and the value of the ETF will likely fall. This has been the case for USO over the years which has returned -20.22% annually over the last 10 years meaning it has fallen about 89.55% during that time.
However, the latest problem with USO is that so many retail investors had poured into the fund lately, $2.9 billion in the first quarter of 2020, that it was reported by Bloomberg News to then control 25% of all the May deliverable futures.
USO is not in the business of taking deliverables of oil and to make matters worse, the demand shock had filled all the storage around Cushing to capacity. The manager of the ETF, US Commodities Funds LLC and the administrator BNY Mellon, correctly deduced that they had a problem on their hands if they had to get rid of a quarter of all May WTI futures contracts in the next week. So last week they announced that they were going to shift the fund’s purchases to hold as much as 20% of its holdings in 2 month futures rather than 1 month futures. This didn’t seem to stem the tide enough and when they likely tried to offload the contracts today, negative prices ensued.
Source: CNBC
The Dangers of ETF’s
As of Tuesday morning, the stop gap of the June contracts is also looking wobbly, falling to $11.79 a barrel. If they aren’t planning it already, there is a real chance that USO will liquidate and leave its investors with a 100% loss on their principal investment.
I have spoken in the past about how ETF’s are like the democratization of finance in the sense that they allow the little guy to take positions that in the past were only reserved for the ultra wealthy or hedge fund managers. These are great tools for people that know what they are doing such as wealth advisors and sophisticated retail investors. The problem it seems is not that there is an ETF bubble but the classic issue of having unsophisticated retail investors pouring into investments with little understanding of their mechanics.
I think it likely that many of the retail investors piling into the USO ETF have much of any idea how the ETF is structured and have a sense of how rolling 1 month futures contracts for Cushing WTI work. They likely just were moved by headlines about crude crashing for months, decided to make a long bet that it won’t be worthless and decided USO was a good way to speculate on the price returning to a more normal level.
Little did they know that the ETF was not like some of the gold ETF’s which hold receipts for vaults where physical gold is stored. The USO ETF only trades in 1 month (and now 2 month as well) futures contracts to try to mimic the spot price of oil.
The good news for investors in this fund is that all contracts did not trade negative yesterday. Only about 100 or so contracts did but these were closed towards the end of the trading session and therefore left the last prices as negative. The weighted average price for the contracts yesterday was around $8 a barrel. This, along with the move into 2 month futures for USO is likely what kept the fund from liquidating, but dark headwinds are on the horizon.
I believe that people should inform themselves and if they want to place their money in something without any understanding of the underlying mechanics then they should have to take responsibility when they get burned. Unfortunately that isn’t always how it works and the long term consequences for this could be greater than just some losses for speculators. If USO liquidates and produces large losses for its holders, we may see regulators come in and start to restrict retail holdings of some ETF’s. They already do this for private equity and other investments, that’s where the accredited investor concept came from.
So please, take the time to do your homework before putting your hard earned money on the line, you’ll benefit more than just yourself over the long run.
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