The closure of Deutsche Bank’s Powershares DB Crude Oil Double Long exchange-traded-note this week sent a sizable ripple through both the exchange-traded products and commodities space.
For the commodity markets, specifically, the concern was how prices might react when the fund is forced to liquidate its positions on September 9.
Accordingly, it’s interesting to see that even Deutsche Bank’s own commodities research team appeared a tad concerned about the matter on Friday (H/T the FT’s Gregory Meyer). As the analysts wrote:
The implications of redeeming a fund could have interesting implications for commodity prices, forward curves and volatility. For example, assets under management of the DXO fund stand at roughly USD400m as of September 2. Since the ETN has a two-for-one exposure in the oil market, it has approximately USD800m invested in the WTI July 2010 futures contract. Assuming an oil price of USD68/barrel, this is equivalent to 11,750 futures contracts and consequently exceeds the position accountability levels governing the WTI sweet crude oil futures contract listed on NYMEX.
So essentially, in Deutsche’s opinion, a regulatory-inspired move aimed at curbing oil price volatility will, in the short-term at least, encourage more volatility, not less.
The analysts also keenly pointed out that in the long term, the new regulatory environment could, ironically, increase the appeal for investors to take delivery of commodities. As a result, what has tended to be a financial exposure to commodities might become more physical with, in their view, a more direct impact on commodity prices.
They added that a similar rule was only introduced to the wheat market when the so-called ‘basis’ — the difference between the average cash and futures price — began to soar, a reflection that there was indeed an unjustified disconnection between the futures and physical market. In energy markets, however, there has been no evidence of a comparable move in the basis. As Deutsche put it:
…an examination of the basis in other commodity markets suggests the experience of the wheat market is unique. Indeed one could argue that a much larger increase in crude oil futures trading has occurred over the past few years, yet the basis in this market has not moved to the same degree as that for wheat, Figure 4.
Nevertheless, by now it appears clear the above won’t be deterring regulators from instituting stricter limits. The question is, are regulators aware of the fact that by encouraging ETF futures liquidation, their actions might drive investors further into the physical market and via that turn a weak basis into a strong one. As Deutsche noted:
We find that of the top 20 ETF/ETNs in terms of market capitalisation roughly 70% have been launched in the last two-and-a-half years. The majority of these have tended to be concentrated in the energy sector and specifically ETFs with crude oil and US natural gas as the underlying.
Not surprisingly attention has turned to other ETFs such as the US Natural Gas (UNG) and United States Oil (USO). We estimate that with assets of USD4.4bn and USD2.0bn respectively the liquidation or redemption risk if both these funds were closed is equivalent to approximately 165,000 US natural gas contracts and 30,000 WTI crude oil futures contracts respectively.
In terms of USO, OIL and DXO, these ETF/ETNs have a combined exposure to the WTI crude oil market of roughly 50,000 contracts. If we include the major composite ETFs such as DBC, GSG and DJP, which track a broad commodity index rather than an individual commodity, alongside the individual commodity oil ETFs these have a combined exposure to the WTI crude oil market of 87,640 contracts albeit spread across various parts of the oil forward curve.
The DBC and DBA, which represent two of the top three ETFs globally in terms of market capitalisation, have exposures that are split across a number of commodities. The DBC tracks the DBLCI-Optimum Yield excess returns index. This constitutes six commodities, WTI, heating oil, aluminium, gold, corn and wheat whose current weights are 37.5%, 17%, 12%, 14.4%, 8.9% and 10.2% respectively. As a result, liquidation risk on the DBC at the extreme would be equivalent to 18,900 crude oil contracts, 8,000 heating oil contracts, 11,000 aluminium contracts, 5,000 gold contracts, 19,700 corn futures contracts and 15,400 wheat futures contracts. Figure 7 examines the possible scale of liquidation risk for various ETFs/ETNs as they relate to the energy sector.
And most importantly concluded:
Second the proliferation of commodity ETF/ETNs has been concentrated in the energy sector. We estimate that of the major ETF/ETNs, exposure to the crude oil and US natural gas markets alone is approximately equivalent to a combined 88,000 and 145,000 contracts respectively. However, the irony of CFTC action to curb speculative activity is that we believe it may simply encourage investors to take delivery and store physical commodities in essence investors become commodity consumers. If this occurs it may have exactly the opposite effect from which the CFTC is trying to achieve, namely lowering commodity prices as a new source of physical demand starts to enter the market.
Of course, the most accessible physical market to all retail investors due to its low storage costs is gold — which might explain some of the sudden moves into physical-based products this week.
To see the full note in the Long Room click here.
Related links:
Looking at precious metal flows - FT Alphaville
How effective are speculative limits in commodities anyway? – FT Alphaville