The blowup of leveraged exchange-traded products is old hat by now. But the recent price action in West Texas Intermediate raises the prospect of the unthinkable: A relatively plain-vanilla fund that offers investors exposure to fluctuations in crude prices might be worth less than nothing.
The US$4.1 billion United States Oil Fund LP (ticker USO) slumped about 11 per cent to a record low on Monday as the front-month West Texas Intermediate contract made an unpredecented drop below zero, throwing into sharp relief the dearth of demand and storage capacity for the commodity stateside. The ETF tumbled 32 per cent to 12:44 p.m. in New York Tuesday.
USO didn’t own any May futures, with its roll into the June contract scheduled to have been completed by April 13. Its two biggest positions are in the June and July West Texas Intermediate contracts. The net asset value of its holdings could drop below zero in the event the June contract falls well below zero before the projected roll of the position, scheduled to take place from May 5 through May 8.
An exchange-traded fund has not and cannot trade below zero, according to Bloomberg Intelligence senior ETF analyst Eric Balchunas.
Last week, the fund announced a reallocation of its holdings, aiming for 20 per cent exposure to the second-traded future rather than concentrating completely in the front month. Further adjusting this positioning could help protect against the net asset value of its holdings falling below zero. The lack of storage capacity in the near-term is the proximate cause for the May contract’s swoon into negative territory, while contracts further out the curve remain in positive territory for now.
Wall Street strategists are speculating about the possibility that a move below zero for the front-month contract this time could prove much more damaging to USO.
“Additional hypothetical: the desk notes that despite there not being a redemption mechanism, there is certainly a scenario where if June futures were to also go negative, then USO would be ‘lights out’ as a partnership and could actually ‘owe’ money,” writes Charlie McElligott, cross-asset macro strategist at Nomura Securities. The product’s holdings account for roughly 30 per cent of open interest in the June futures contract, he added.
The fund’s prospectus allows for the termination of the fund on a discretionary basis, or resulting from the bankruptcy, dissolution, withdrawal, or removal of the United States Commodity Funds LLC. “However, no level of losses will require USCF to terminate USO,” according to the prospectus.John Love, president of USCF LLC, did not immediately respond to phone calls or an emailed request for comment.
Rebecca Babin, senior energy trader at CIBC Private Wealth Management, talked to Bloomberg TV about the uncertainty regarding who might be exposed in the event that worst-case scenarios for USO come to pass.
“There has been some speculation that the CME or the clearing exchanges may be somehow on the hook for that, or the ETF provider,” she said. “Unclear right now, if the June contract were to go negative who would be on the hook for that but it is certainly part of the enhanced volatility we’re seeing around the trading, both in WTI and in USO today.”
In the case of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), the exchange-traded product that offered inverse exposure to short-term volatility futures, language governing so called “acceleration events” that could result in its closure were clearly outlined in the prospectus. Credit Suisse announced the early redemption of XIV on Feb. 6, the day following an unprecedented doubling in the VIX Index that saw the indicative intraday value of the short-volatility product plummet by more than 80 per cent.
USO posted a record inflow last week as traders speculated that depressed oil prices had nowhere to go but up, bets that have since soured spectacularly.