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The United States Oil Fund (NYSE:USO) has taken a series of unusual actions as the impact of crude’s swoon was exacerbated by wrinkles in the structure of the markets where it operates. The security, which has lost a third of its value in two days, had to suspend the issuance of new shares, an action that could leave it untethered from prices it’s supposed to track.
The episode has shown how seemingly simple products for wagering on a commodity price can get complicated in a hurry, particularly when instruments like crude futures and ETFs interact. About $3.3 billion of value is still at risk in a stock-market product that, in a quest for self-preservation, is making on-the-fly tweaks to rules that have guided it for years.
“The majority of retail investors in this product probably had no idea what these nuances are,” said Ben Johnson, Morningstar’s co-head of passive strategy research. “There’s probably also a portion of them too that fundamentally don’t understand what it is they’ve signed up for — that there’s no investment product that gives you pure unadulterated exposure to movements in the underlying commodity.”
To be sure, a ton of pain was awaiting anyone speculating that oil would rise. The ETF isn’t itself responsible for the crash in crude, and actions by its overseers have on several occasions kept losses for its owners from spiraling. But extraordinary buying and selling by the fund, the biggest player in oil futures, may be adding to the velocity of the swings, creating feedback loops that some analysts warn could themselves impede a recovery.
Among measures forced on the fund in the past few days has been the loosening of rules dictating which futures it holds. As near-term contracts plunged amid a panic about where to put the oil that they obligated owners to receive, USO has scrambled to move its holdings into longer-dated contracts.
Rejigging Holdings
On Tuesday, USO changed its holdings to keep about 40% of its portfolio in the most active June contract, while parking even more in July and 5% out in August, according to a regulatory filing. The step — which anchored the ETF to contracts that, while down, have fallen less violently than near-term ones — was due to “ongoing extraordinary market conditions” in the crude oil market, the filing said. At this point the fund may invest in whatever contracts are available.
Retail investors looking for a bottom to the rout have flocked to the ETF in recent weeks. Their purchases led to another complication in the ETF’s rigging. So much stock was issued to account for their demand that the security exhausted the number of shares it was allowed to issue under past filings. USO on Monday had asked the U.S. Securities and Exchange Commission for permission to register an additional 4 billion shares, according to USCF, which runs the ETF.
Until the new shares are cleared by the SEC for issuance, the oil ETF will not purchase more West Texas Intermediate oil futures, according to analysts, potentially adding to pressure on crude prices that have plunged after the coronavirus took a massive toll on global fuel demand.
Trading Questions
USO closed Tuesday at $2.81, down 33% in two days, though its 25% loss Tuesday was dwarfed by the drop in June futures. Trading of USO shares on the NYSE Arca, Inc. won’t be discontinued as a result of the suspension of sales of creation baskets, the company said in the filing announcing it had run out of shares to issue.
Famed oil trader Pierre Andurand said earlier in the day that he thought the CME Group (NASDAQ:CME) would have no other choice but to close out long-oil ETF positions because of the risk of negative prices. “Anything that invests in the front two months of WTI is a recipe for disaster,” he added in an interview with Bloomberg TV.
In effect, until the new shares are cleared, the oil ETF will have characteristics of a closed-end fund, with no easy way to keep its price aligned with the underlying commodity. Closed-end funds often trade at sizable discounts or premiums to the market value of their constituents, since there’s no way to offset buying and selling demand in the secondary market by adjusting the supply of shares. USO closed at a premium of roughly 8.4% to its net-asset value on Friday.
Arbitrage Blocked
John Love, president of USCF LLC, didn’t immediately respond to request for comment.
The fund held 23.5% of June West Texas Intermediate crude futures contracts on the New York Mercantile Exchange as of Monday.
Normally, specialized traders known as authorized participants will sell shares of a rallying ETF and purchase the underlying securities to pocket a virtually risk-free profit. That process usually keeps the ETF’s price in lockstep with the fund’s net asset value. However, with the authorized participants no longer able to create shares, that arbitrage trade has been disrupted.
Demand Dynamics
Since demand for the oil ETF has been running incredibly high, the secondary market is likely to create upward price pressure on its stock. At the same time, with no new shares being created, market makers have less incentive to purchase oil futures to exchange with the fund. The elimination of those buyers could effectively put downward pressure on the underlying commodity — offsetting some of the upward pressure on the stock.
“The ETF will trade at a larger premium versus its net-asset value, and potentially cause a short squeeze in the short-term,” said Mohit Bajaj, director of ETFs for WallachBeth Capital. The authorized participants “can’t buy the ETF shares at NAV,” he said. “There is no way to source shares now. You have to buy it in the open market, causing the price to ramp up higher — more than what it’s potentially worth.”
Investors looking to bet against the ETF may explain some of the demand for new shares, according to JonesTrading’s Dave Lutz. In the so-called create-to-lend process, new shares of an ETF are generated in order for traders to borrow and sell short.
Short Squeeze
With the current halt of new-share creations, USO is likely to become further unmoored from its net-asset value, Lutz said.
“The ETF should completely disconnect from fundamentals and could cause a hell of a short squeeze,” he wrote in a note Tuesday.
Other funds are feeling the stress as well. Horizons ETF Management said on Tuesday that it will not accept new subscriptions for shares of its BetaPro Crude Oil 2x Daily Bull ETF or its twice-leveraged daily bear ETF, while redemptions will continue to be accepted.
Meanwhile, Barclays (LON:BARC) Plc said late Monday it will suspend further sales and issuance of its iPath Series B S&P GSCI Crude Oil Total Return Index ETNs immediately, and exercise its issuer-call option and redeem in full at the end of the month.
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