Is WTI becoming an ETF derivative? | FT Alphaville

Is WTI becoming an ETF derivative?

It’s rollover day for the March WTI contract on Friday. And the WTI disparity continues to hold, something analyst Olivier Jakob at Petromatrix increasingly thinks has more to do with the United States Oil Fund (USO) than any real fundamentals. As can be seen below, the divergence between the WTI and Brent contracts, which usually track each other quite efficiently, has really intensified in the last few months.

On Friday, the Nymex WTI contract was trading around $37.38 per barrel, while the ICE Brent contract was at $40.55.

What’s really worrying Jakob, however, is the soaring size of the USO in particular – even despite relatively dismal returns since the start of the year. The fund’s NAV is down 33 per cent year to date.

At the current rate of expansion, Jakob expects the fund — operated out of California by former (unsuccessful) US Republican candidate for congress Nicholas Gerber — to hit 100,000 WTI futures contracts by Monday.

Just to compare, this time last year the fund held only 2,855 WTI futures.

USO growth - Petromatrix

At those levels the fund now controls some 20 per cent of the open interest on the April Nymex WTI contract, and 30 per cent of the same contract on the ICE exchange. As Jakob puts it:

We remain of the opinion that the USO WTI ETF has now past the equilibrium point where the WTI futures front contract has become a derivative of the ETF rather than the ETF a derivative of the futures contract.

He adds (our emphasis):

For that reason we would have any crude oil length in Brent rather than in WTI. If any length on WTI we would use the current narrowing of the front spreads to already move any long positions from April to May and finance the future roll of length from May to June with a short position on the April-May spread. (On a side note: the ETF in the most bizarre of move is starting to shift some of the WTI holdings into the NYMEX WTI Financial contract, which is clearly odd as there is no liquidity in that contract ie a total of 7’100 Open Interest on April WTI).

The USO, regulated by the SEC, announced in a filing on February 13th that it would be changing its roll day from one day to four as of March 6th. However, that information was kept very low key by the fund. Only a chance nose around the filings by FT Alphaville actually brought the change in rolling date largely to the market’s attention.

At this point, the key question on people’s mind is just who is putting so much money into the USO? Can it really all be retail investors when the returns are so unappealing? Currently the fund has just over $4bn under management, with 154.3m units outstanding.

According to Paul Justice, an analyst at Morningstar who tracks commodity ETFs, appetite for commodity funds is high, and many ETFs — particularly gold and oil ones — have seen a sharp influx of inflows as investors look for safe havens. The growth in the USO is not surprising to him as a result. While USO returns suffer on account of the negative roll at present, Justice says most investors investing in the ETF are looking at a longer-term view of the market. In a report on the fund, Justice wrote:

Though its tracking is not perfect, the simplest reason to own United States Oil is that you believe oil prices are going up.

The catch is that the futures curve–that is, the prices of contracts with progressively longer terms–can take an upward (known as “contango”) or downward (“backwardation”) slope. That slope can cause futures and spot returns to decouple. For instance, until recently, contango caused oil futures returns to lag spot prices. In fact, this fund’s returns have routinely lagged and surpassed spot prices since its April 2006 inception. The upshot is that those dynamics can make funds like this an imperfect hedge of crude oil prices.

This ‘ETF’ is really a limited partnership, a structure whose tax implications are both considerably different from traditional equities and can catch uneducated investors off guard. We’ll summarize some of the issues here, but we would recommend consulting your tax professional before diving into these shares. Rather than receiving a summary form 1099 at the end of the year, investors will receive a schedule K-1 to report their portion of the company’s earnings. So even if investors do not sell their shares, they may have to report an amount that is taxed as ordinary income. Furthermore, because this fund does not ever intend to distribute any funds to its limited partners, most buy-and-hold investors will have to dig into their own pockets for any tax bill.

This fund’s fee varies based on the assets under management. The first part of the fee goes to the General Partner, which sits at 0.50% for the first $1 billion and 0.20% on assets above that threshold. The remainder of the fees cover commissions and miscellaneous expenses, which added another 0.36% during 2008. In aggregate, the fee floats closely to 0.86% today.

Justice says there are about 120 such ETFs, of which the USO is now by far the largest oil one.

Related links:
A cancer in the oil markets?
– FT Alphaville