Olivier Jakob at Petromatrix continues his crusade against the United States Oil Fund in his Tuesday note, an issue increasingly being picked up across the commodities and investment spectrum.
Jakob’s specific case is with the distortions being caused in the WTI market on account of the ETF’s size and predictability. He notes people are already rolling positions from the front-month April contract and into May just to avoid the distortions. This is making the front-month contract somewhat of a farce, with a number of oil traders telling FT Alphaville the contract’s viability as a hedging instrument is truly in question. The volatility, meanwhile, is also immense relative to any other contracts further down the curve.
Consequently, Jakob calls it a USO free-lunch:
Open Interest data for Friday is confirming that positions are already being rolled into May. This is unusual to have positions being rolled so early before the next expiry but the USO has created a different crude oil market. The front timespread on WTI (Apr/May) is logically starting to weaken as length is taken out of April WTI and as traders start to position themselves for the USO free lunch. This in turn is making for a wider Brent premium to WTI and an improvement of the product crack. If Petrologistics is right on the level of compliance then given that WTI will remain for a while distorted on the USO rolls, this could make for an even wider prompt premium of Brent versus WTI and a strong rebound of US Gulf cash physical values during the roll of indices.
To make the point Jakob produces this rather nifty chart. He seems to have a point:
Of note, of course, is the exponential increase in the ETF’s open interest since November 2008, as illustrated below courtesy of Jakob.
Of note too, is the fact the industry happily front-runs the fund’s roll every month, presumably making a tidy profit from the distortations. Because of the nature of the contango, the ETF is also taking a loss on its NAV every time it rolls, leading to substantial underperformance versus the WTI contract which it is supposed to be tracking. On Monday, for example, closed at a value of $23.32 per unit. That’s significantly below the Nymex WTI settlement of $38.44 on Monday. Returns for anyone invested in USO ETF units have therefore been dismal, and yet the fund community would have everyone believe a mass of investment demand, presumably from retail investors who know no better (because surely a professional would see the problem), is what is forcing the fund to issue increasingly more units, taking up ever more WTI contracts as it does.
Now there are three potential scenarios.
1) The fund really is in such high demand, and investor appetite is forcing the ETF’s general partner to purchase more WTI contracts so as to issue increasingly more units to maintain the units’ valuation in line with WTI to the degree set out by the prospectus.
Indeed, as the USO prospectus outlines (our emphasis):
As a specific benchmark, the General Partner endeavors to place USOF’s trades in Oil Futures Contracts and Other Oil Interests and otherwise manage USOF’s investments so that A will be within plus/minus 10 percent of B, where: • A is the average daily change in USOF’s NAV for any period of 30 successive valuation days, i.e., any day as of which USOF calculates its NAV, and • B is the average daily change in the price of the Benchmark Oil Futures Contract over the same period. The Benchmark Oil Futures Contract is changed, or ”rolled” from the near month contract to expire to the next month to expire during one day.
Which brings us to:
USOF invests in oil interests to the fullest extent possible without being leveraged or unable to satisfy its current or potential margin or collateral obligations with respect to its investments in Oil Futures Contracts and Other Oil Interests. The primary focus of the General Partner is the investment in Oil Futures Contracts and the management of its investments in short-term obligations of the United States of two years or less (”Treasuries”), cash and/or cash equivalents for margining purposes and as collateral.
USOF creates and redeems units only in blocks called Creation Baskets and Redemption Baskets, respectively. Only Authorized Purchasers may purchase or redeem Creation Baskets or Redemption Baskets. An Authorized Purchaser is under no obligation to create or redeem baskets, and an Authorized Purchaser is under no obligation to offer to the public units of any baskets it does create.
However, what we must add to scenario 1) is the fact that in the current contango market the ETF’s units are allowed to underperform WTI.
As the prospectus outlines:
Conversely, in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ”contango” in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.
What that means, effectively, is that when deciding the fair value of the units the General Partner is obliged to reflect the losses incurred to the NAV via the fund’s roll. We know the losses are large as the fund is now worth some $4bn having been worth less than $1bn even last year (the bigger the fund the less effective its roll will be plus there are more contracts to take a loss on). We also know the losses are substantially more than what might normally be presumed under a contango structure because of the intensity of the “super contango” itself — particularly at the front end — as well as the related volatilty it is inducing in front-end spreads.
In the event of a perpetual contango and no new inflows this would presumably oblige the USO to self destruct eventually. Of course, such a “black-swan” scenario would have seemed distinctly unlikely in 2006 when the ETF’s methodology was first constructed — the depth and scale of the distortions being relatively unprecedented in recent WTI history. In the current climate, however, all manner of black-swan events are becoming distinctly more white-ish.
Interestingly, the mass new inflows happen to mirror the moment the WTI curve went into super-contango. This is a very fortunate coincidence for the fund, for it assures contango losses are diluted — a relative lifeline with every new issue. To explain – every new issue brings a new set of WTI positions which have not “lost out” due to previous consecutive negative rollovers.
Scenario 2) is that someone is methodically abusing the USO specifically to benefit from the profits incurred from front-running the fund in the WTI market itself. Of course, driving up the price of USO units to the extent that the fund is forced to increase its size 10-fold would be a costly operation for any one institution. It is possible there has been a systemic arbitrage opportunity unlocked by the trading community, all of whom – having identified an unsophisticated party in the oil markets — have decided to take advantage of their inexperience by doing exactly that. But there is one problem here, the situation would leave participants exposed to further downside in the USO. Perhaps it’s a risk some might be prepared to take, but it is a risk no less — even if selling-out is an option at any time due to the ETF’s liquidity.
And then there is a third factor, which may or may not be related. SEC filings show a mass spree of reverse convertible note issues linked to the USO (either outright or as a component) in the last few months. These have predominately been issued by Barclays, with a few by Morgan Stanley and one by RBC. An extensive but not exhaustive search of the filings by FT Alphaville identifies this rush of issuance only began in December 2008.
The issues have become increasingly frequent coming into February, with some referring to disclosed sums and others not. At the last count there were 11 issues by Barclays ranging between $1.5m and $2m when sums were disclosed – the latest dated Feb 23rd is here, and three issued by Morgan Stanley at sums of $4m and one undisclosed, one by Bank of Canada for an undisclosed sum and one at JP Morgan issued Feb 24th.
Reverse convertibles are effectively equity derivatives structured as short-term securities that allow the seller/dealer to minimise downside risk on equities they own, while maintaining the upside.
This could highlight the banks’ desire to limit an existing exposure to the USO, potentially one taken on intentionally by the bank for trading purposes, or possibly via the banks’ position as a market maker or authorized purchaser of the units, which it may or may not be having trouble shifting to market.
As far as the USO structure itself goes, as discussed above, it is the general partner who is actually charged with creating fresh units when needs be. According to the USO prospectus the marketing agent then executes the order or “creation” of the units by soliciting orders, customers and customer funds in connection with the offering of the units. Accordin to USO this person is Kathryn D. Rooney, a registered representative of the Marketing Agent. From the prospectus:
Ms. Rooney is also the Director of Business Development for Ameristock Corporation, an affiliate of the General Partner, and is not an employee of the General Partner. As a consequence, she receives no compensation from the General Partner even though she is designated as the Marketing Manager of USOF. Any compensation she receives for her efforts on behalf of USOF is paid by the Marketing Agent. Previously, she worked at ALPS Mutual Fund Services, Inc. as a National Sales Director. She is also registered with the CFTC as an Associated Person of the General Partner. The offering of baskets is being made in compliance with Conduct Rule 2810 of FINRA. Accordingly, Authorized Purchasers will not make any sales to any account over which they have discretionary authority without the prior written approval of a purchaser of units.
By executing an Authorized Purchaser Agreement, an Authorized Purchaser becomes part of the group of parties eligible to purchase baskets from, and put baskets for redemption to, USOF. An Authorized Purchaser is under no obligation to create or redeem baskets, and an Authorized Purchaser is under no obligation to offer to the public units of any baskets it does create.
Here’s the structure graphically set out:
FT Alphaville has contacted Barclays and the USO by email seeking further explanation.