The United States Oil Fund (USO US), the largest ETP globally to track changes in oil prices, is facing a regulatory reckoning after the US Securities and Exchange Commission recommended that the fund and its management face enforcement action, according to a Form 8-K filed by United States Oil Fund, LP.
The SEC has informed USO, USCF, and Love of impending enforcement action.
The filing notes that the SEC has issued USO, its issuer United States Commodity Funds (USCF), and John Love, the firm’s CEO, with a so-called “Wells notice”, a letter informing the recipients of impending action.
A Wells notice is neither an actual charge of wrongdoing nor a final determination that a law has been violated. Instead, the letter presents the recipients with an opportunity to submit their defense in a bid to stave off formal action.
The potential charges against USO, USCF, and Love relate to USO’s disclosures in late April and early May of this year regarding constraints imposed on USO’s ability to invest in oil futures contracts.
Specifically, the notice alleges violations of Sections 17(a)(1) and 17(a)(3) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, in each case with respect to its disclosures and USO’s actions during that period.
Extraordinary market conditions during April and May saw the fund make several drastic changes to its investment strategy in a series of moves that have been lambasted by some investors as not being properly disclosed.
The accused have indicated their intention to fight their corner. The Form 8-K filing notes that “USCF, USO, and Mr. Love maintain that USO’s disclosures and their actions were appropriate. They intend to vigorously contest the allegations made by the SEC staff in the Wells Notice and expect to engage in a dialogue with the SEC staff regarding this matter.”
The Wells notice is the latest blow for USCF as the firm is currently facing a series of class-action lawsuits over USO’s management that have been brought independently by several law firms including Robbins Geller Rudman & Dowd, Rosen Law, and Johnson Fistel.
The outcome of the class-action lawsuits, as well as the potential clash with the SEC, is probably unlikely to significantly affect USO, however. At least in the short term. The ETP, which currently houses $4.2 billion in assets under management, remains the go-to product for crude oil ETP exposure in the US due to its large size and ample liquidity.
Context
Crude oil prices sunk to record lows this year due to a supply glut driven by sparring oil-producing nations and the Covid-19 pandemic’s impact on global demand.
The price of West Texas Intermediate (WTI) crude oil was overly affected due to acute storage issues associated with oil produced in the US. In April, the expiring WTI contract for May delivery sank far below zero as traders were desperate not to be stuck with oil they were unwilling or unable to take delivery of.
The price crash drove the futures market for crude oil into a state of ‘super contango’, where the price of futures contracts with later delivery was significantly higher than those with nearer delivery, leading to high rolling costs for investors.
During this turbulent period, USO, which historically provided exposure to front-month WTI oil futures contracts trading on NYMEX and ICE, began experiencing strong inflows from a mix of speculative traders – bullish investors seeking long exposure in case of a rebound in oil prices, as well as bearish investors seeking new shares to enact short positions. Over $5.8bn flowed into the ETP during March and April.
USO’s rapid growth caused the ETP to reach its position limit on individual futures contracts – regulation from the Commodity Futures Trading Commission states that no single investor may purchase over 25% of a given futures contract.
In response to this, USCF implemented substantial changes to USO’s investment strategy.
In a series of rapid-fire filings, USCF revised USO’s mandate to invest in a mix of WTI futures contracts with delivery dates stretching out as far as June 2021. The sponsor also expanded the mandate to include futures contracts for other types of oil and hydrocarbon fuel.
These actions, which USCF’s critics allege were not adequately disclosed to investors, reduced investors’ exposure to the subsequent recovery in spot oil prices which began trending upwards near the end of April.