Contango and the Known Risk to ETFs
Contango, ETFs, and Alligators
(Note: companies that could be impacted by the content of this article are listed at the base of the story [desktop version]. This article uses third-party references to provide a bullish, bearish, and balanced point of view; sources are listed after the Balanced section.)
There is a lake two miles from my house in Florida, where I regularly waterskied before the county-wide lockdown of public parks. Years back, as a transplanted New Yorker, the idea of jumping into a beautiful but dark freshwater lake wasn’t comfortable. After-all, Lake Ida is connected to a chain of alligator-infested waterways. But I set out to educate myself, then decide if the other people in the lake were taking more risk than I cared to. My education included boating with a number of experienced friends whom I believed to be both sane and knowledgeable. I also researched the fears of the primitive reptiles; I Googled information on their food preferences and even their mating habits. My skiing partners thought I was ridiculously cautious. I didn’t care. If I can’t see below the surface of something, I need to gauge the risk in another way.
Eventually, I learned what I needed to and became a regular slalom skier on Lake Ida, surrounded mostly by wakeboarders and tubers. Although the activity from all the other boats doesn’t make the best conditions for running a slalom course, it does, to the best of my understanding, keep alligators away. So, as long as there is a ruckus going on up top, I feel confident that the sharp-toothed creatures below will leave for quieter waters.
On Thursday, I took a bike ride over to the lake to get out of the house and see what it looks like after six weeks of close to zero boat traffic.
It was exceedingly quiet. The prolonged lack of activity concerned me. Although I can’t be sure, I’d think that almost zero boat traffic from the coronavirus lockdown may have changed the risk of entering the water. There has been nothing for weeks to spook the gators. I will not rush back onto Lake Ida with my ski soon after the county allows.
The lockdown has unecpectedly changed the risk profile of many seemingly unconnected activities. Health and what is now necessary to stay healthy tops the list, investments, and finding returns while staying out of trouble probably fall into people's top three on their list. Investing should, the environment has changed, and clarity is harder to come by.
Below the Surface of an ETF
Last week, retail investors, many trading off free apps such as Robinhood and SoFi Invest, learned an expensive lesson. They continued to pile into a popular ETF while it continued to move lower. The fund may have looked like it offered greater and greater value as it became cheaper and cheaper versus crude oil, which it was expected to track. However, thus far, that has not panned out. On the other side of the trade, selling into the frenzy, were more aware professionals who were shorting the ETF. This worked well for the more experienced professionals who pulled in as much as $286 million and may have earned as much as 110% (Feb. 27 to April 21).
The underlying positions in ETF ticker symbol USO (United States Oil Fund, LP) had for years been the front-month oil futures contracts. Last week, USO redefined and “loosened” their mix two times. The new “allowable” universe veered dramatically from what many ETF investors expected from their investment. As they announced the changes, which were dramatic and includes an 8 for 1 reverse stock split and a temporary structure as a closed-end fund,
it seemed to attract even more unaware investors. A large number of the buys transactions were transacted on apps, the demographic was young investors. It’s presumed that most didn’t know what the underlying investments were in the ETF. That is because the investments now allowed is so varied that it isn’t possible for investors to know what category of oil exposure they own.
“Given the way disclosures are currently being given by the fund, it’s almost unanalyzable, because you don’t have a sense of what the weighting along the futures curve is…” - Peter Cecchini, Chief Market Strategist, Cantor Fitzgerald
Staying On Top of your Investment
On Wednesday (4/22/20), virtually every oil contract traded higher. USO, which investors had thought of as a proxy for the price of oil fell 10.6% that day. This decline contributed to the 40% spiral over three consecutive trading days, and to the 80% pounding USO owners have taken on the year.
Broadening the expiration date of the futures contracts USO will transact in was likely adopted by the fund managers as a self-preservation measure after the May Oil Futures Contracts had experienced a selling frenzy. The selling left the price of the contract negative. The reason for the negative price is that holders of the contract are expected to take delivery. Worldwide storage for crude oil is at capacity. Taking delivery could mean filling a ship and letting it sit idle until the glut burns off. When the futures price and spot price of a commodity don’t converge as expiration nears a situation market participants call “contango” occurs. Contango can wreak havoc in ETFs that invest in futures contracts rather than actual commodities.
USCF is the manager of USO. They have as their tagline “INVEST IN WHAT’S REAL." At the moment, it is difficult or impossible to know what is real with their fund. On April 28, the reverse 8 for 1 stock split will take place. This resulting higher cost of share price may dissuade some of the smaller investors that prefer more shares and lower prices. USOs lower price has attracted inflows every day since April 8, for a total of about $3.3 billion. Demand for the ETF was so high that the fund exhausted the number of shares it was allowed to issue under past filings. USO has asked the U.S. Securities and Exchange Commission for permission to register an additional 4 billion shares, according to USCF, which runs the ETF.
Determining what an investment will do next is never certain. But taking a view on an ETF with uncertain investment parameters may be riskier than it needs to be. USO is the biggest exchange-traded fund tracking oil right now. Wall Street veterans want no part of it., except perhaps as a short. Small investors may want to wait investors until the contents below the surface is better understood.
Sources:Short sellers make nearly $300 million betting against retail investors’ favorite oil fund