Wall Street warns biggest oil ETF could go ‘lights out’ after 30% drop
The blow-up of leveraged exchange-traded products is old hat by now.
But the recent price action in West Texas Intermediate raises the prospect of the unthinkable: A relatively plain vanilla fund that offers investors exposure to fluctuations in crude prices might be worth less than nothing.
The US$4.1 billion United States Oil Fund LP (ticker USO) slumped about 11 per cent to a record low on Monday as the front-month West Texas Intermediate contract made an unprecedented drop below zero, throwing into sharp relief the dearth of demand and storage capacity for the commodity stateside. The ETF tumbled 32 per cent in mid-afternoon New York trading on Tuesday.
USO didn’t own any May futures, with its roll into the June contract scheduled to have been completed by April 13. Its two biggest positions are in the June and July West Texas Intermediate contracts. The net asset value of its holdings could drop below zero in the event the June contract falls well below zero before the projected roll of the position, scheduled from May 5-8.
An exchange-traded fund has not and cannot trade below zero, according to Bloomberg Intelligence senior ETF analyst Eric Balchunas.
Last week, the fund announced a reallocation of its holdings, aiming for 20 per cent exposure to the second-traded future rather than concentrating completely in the front month. Further adjusting this positioning could help protect against the net asset value of its holdings falling below zero. The lack of storage capacity in the near-term is the proximate cause for the May contract’s swoon into negative territory, while contracts further out the curve remain in positive territory for now.
Wall Street strategists are speculating that a move below zero for the front-month contract this time could prove much more damaging to USO.
“Additional hypothetical: the desk notes that despite there not being a redemption mechanism, there is certainly a scenario where if June futures were to also go negative, then USO would be ‘lights out’ as a partnership and could actually ‘owe’ money,” writes Charlie Mcelligott, cross-asset macro strategist at Nomura Securities.
The fund’s prospectus allows for the termination of the fund on a discretionary basis, or resulting from the bankruptcy, dissolution, withdrawal, or removal of the United States Commodity Funds LLC.
“However, no level of losses will require USCF to terminate USO,” according to the prospectus.