Is US Oil Fund’s Size To Blame For Oil Market Volatility?

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Oil prices made history this week as they fell below zero for the first time.

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In the unprecedented meltdown, the price of the May WTI contract crashed as low as -$37 a barrel on Monday.

Prices went negative because the physical market in Oklahoma and Texas is so overwhelmed. Official US government data shows that storage at the key crude oil hub in Cushing, Oklahoma, was just 70% full as of mid-April. With demand down 30% worldwide, buyers and sellers of oil have little choice but to store excess capacity until demand returns to some sort of normality.

Even though the OPEC+ cartel of oil-producing nations, agreed to historical production cuts last week, these cuts will not take place until May, suggesting the pressure on the market is going to last for a few weeks at the very least.

Some analysts have speculated that trading in oil funds has exacerbated the oil price volatility over the past week.

US Oil Fund's Impact On The Oil Market

As oil prices slumped in the first half of April, traders piled into the USO ETF (United States Oil Fund). The fund mushroomed in size. Since the end of January 2020, assets under management have grown from approximately $2 billion to $4.2 billion.

Retail traders have flocked to the ETF as a way to bet on rising oil prices. Earlier this week, the ETF became the most traded instrument on Robinhood.

US Oil Fund is designed to track the daily price movements of WTI crude oil via futures. The ETF was obligated to invest in front month WTI contracts, which would then be rolled over every month.

As the fund size has grown, its open derivative positions have started to dominate front month open interest. According to Bloomberg, US Oil Fund makes up 25% of all outstanding contracts in WTI crude futures, around the SEC's regulatory limit for a single entity in one market. Figures suggest this could rise to 30% when pending deals are process.

The fund's managers are now looking to change the ETF's investment strategy. In a filing late in the trading day Tuesday, US Oil Fund cited "extraordinary market conditions" and a "super contango" as reasons requiring a change to its portfolio.

The ETF plans to transfer money out of its crude oil futures contracts that will expire in June, to later-dated contracts. This follows a previous decision to allocate at least 20% of the portfolio to later-dated contracts.

The fund's managers are also looking to possibly invest in "other permitted investments" based on energy products.

Interestingly enough, this isn't the first time US Oil Fund has faced problems executing its strategy due to its size.

As a recent article on the FT's "Alphaville" blog notes, US Oil Fund's size also started causing problems in 2008/09 when assets under management "mushroomed" to due inflows from "passive long investors."

The blog goes on to opine:

"As the fund's open derivative positions began to dominate front-month open interest in what was then a contango — and thus loss-inducing — market, the rolls became game-able. The wider market soon realized that if it too piled into the contracts ahead of the fund it could profit at its expense by ensuring it would cost the USO ever more to rollover its positions.

In turn this front-running exacerbated the contango, which increased the profitability of buying physical oil and putting it into storage while selling it simultaneously for a guaranteed profit at some point in the future."

These fund rolls started to have a disproportionate impact on the underlying physical market as a result.

We could be seeing the same scenario unfold. US Oil Fund's decision to diversify its portfolio away from front-month contracts will reduce its impact on the market, but this action could also increase tracking error.

In the meantime, US Oil Fund has been forced to suspend new registrations because the ETF has run out of pre-registered units to provide authorized participants.

ETFs have to pre-register shares in bulk to avoid having to go through a regulatory process every time a share is offered to the market.

Following the recent explosion in demand for shares, US Oil Fund has run into its regulatory limit. Therefore, the fund manager suspended the ability of USO Authorized Purchasers to purchase new creation baskets until such time as a new registration statement for the additional shares has been declared effective by the SEC.

Issuing new shares may only exacerbate the fund's influence on the underlying WTI market. As it has stopped buying front-month futures, for the time being, any buying support these deals may have offered will be removed.

This article first appeared on ValueWalk Premium.

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About the Author

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert began his career as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute For Securities & Investment and the CFA Society of the UK. Rupert covers everything value investing for ValueWalk and co-runs HiddenValueStocks with Jacob Wolinsky Email - [email protected]

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