United States Commodity Funds (USCF) has announced an immediate change to the investment strategy of the $4.9 billion United States Oil Fund (USO US), the largest ETF worldwide to provide exposure to oil prices.
Bullish oil traders have added over $4bn in net new assets to the United States Oil Fund (USO US) since 1 March 2020.
Whereas USO previously invested exclusively in front-month futures contracts for West Texas Intermediate (WTI) trading on NYMEX, the ETF will henceforth dedicate 20% of its assets to tracking second-month contracts.
USCF notes the change in investment approach aims to comply with regulatory requirements and will remain in place until further notice.
Specifically, the new strategy seeks to satisfy regulation from the Commodity Futures Trading Commission (CFTC) which states that no single investor may purchase over 25% of a given futures contract.
US oil prices have plummeted roughly 81% (WTI, May futures) since 20 February, driven by a sharp reduction in energy demand resulting from the pandemic-induced economic shutdown at the same time that a feud between key producers Saudi Arabia and Russia have led to an oversupply of crude oil.
Despite the two nations forming a pact on Easter Sunday to coordinate a reduction in oil output, along with most other OPEC+ members, investors were not impressed with the extent of the deal. WTI crude oil prices fell a further 20% last week and are currently trading at lows not seen for over two decades – the expiring May 2020 WTI Crude Oil contract on NYMEX is currently priced at just $11.22 per barrel (11 GMT, 20 April) as financial traders offload contracts and with few physical buyers to take and store May-delivery oil.
The oil market rout has brought out many speculative traders. USO gathered over $2.2bn in net new assets during March and has picked up another $2.6bn month-to-date (as of close 17 April). The fund’s robust demand likely reflects a mix of 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.
Regardless, the strong inflows led the fund to breach the CFTC’s position limit on individual contracts and forced USCF to begin looking further down the futures curve.
The move offers pros and cons for investors.
Spot prices (front-month futures contracts) often display the greatest sensitivity to updated market news and changes in expectations. Bullish traders hoping to profit from an unexpected pickup in energy demand or the announcement of further curtailments in oil production will likely not realise their maximum gains now that 20% of the fund’s portfolio is invested in second-month contracts.
On the plus side, however, the change in approach reduces the massive rolling costs facing investors in the ETF owing to the oil futures market being in contango (where the price of the front-month contract is trading above the spot price).
The limited maturity of futures contracts requires that soon-to-expire contracts be sold and the proceeds reinvested into futures contracts with an expiry date further in the future. This process is known as rolling over the contract.
As the oil futures curve is currently steeply in contango, investors will realize a negative roll return as they sell their expiring contracts to buy more expensive ones.
With the June 2020 WTI Crude Oil futures contract trading on NYMEX priced at $21.97, this buying high and selling low implies a theoretical gut-wrenching rolling cost (particularly, if rolling is left late in the day). In contrast, the contract for July delivery costs $26.95, implying a less steep erosion of value.
Fortunately for investors in USO, it has already rolled over its exposure into June contracts, thus swerving today’s unprecedented slump.
USO rolls over its contracts over a four-day period, typically completing the process about a week out from expiration.
USO trades on NYSE Arca and comes with an expense ratio of 0.84%.