$3.6bn crude bet puts price on stupidity Robert Guy Senior Writer Apr 22, 2020 – 3.28pm https://www.afr.com/markets/equity-markets/3-6bn-crude-bet-puts-price-on-stupidity-20200422-p54m0t The chaos of negative oil prices unleashed by the expiry of the May West Texas Intermediate contract should sear into investors' minds the real danger of being long "paper" barrels in a massively over-supplied physical crude market. But alas. The depths of recklessness appear to know no bounds when it comes to retail investors and their willingness to risk their hard earned on a bet on a rebound in US oil prices. That's despite the bollocking handed out to the favourite plaything of America's punters: the US Oil Fund. In what looms as a reverse Robin Hood trade in the making, investors on the US millennial platform Robinhood bought into the US Oil Fund during Tuesday trading, a welcome sign for professional oil traders who can rest assured that in coming weeks there will be a collective lap big enough to dump unwanted June contracts into. The US Oil Fund has become a lightning rod in recent days amid the turmoil in oil markets as it has delivered a real-time master class in concepts such as "contango", "roll-over" and "bag holder". The profoundly flawed structure of the US Oil Fund has made its shareholders into bag holders given the underlying assets of the fund – oil futures contracts – took a beating as professional oil traders and commercial buyers dumped their holdings and sprinted for the exits ahead of the May contract expiry. Super contango What you see is not what you get with a commodity-based passive investment such as the US Oil Fund. In an oil market characterised by a super contango, where futures prices are higher than near term prices, the US Oil Fund is forced into monthly rollovers where it sells expiring contracts at a low – or negative – price and then buy futures at a higher price. That eats away at returns. The expiry of the June contract in a month from now is shaping up as an absolute doozy given the glut-o-geddon raining down on all producers. A review of US Oil Fund's latest holdings shows the fund holds nearly 143,000 June WTI contracts traded on NYMEX – with a market value of $US1.7 billion – and 53,500 June WTI contracts traded on ICE, with a market value of $US618 million. That's a $US2.3 billion ($3.6 billion) bet on oil prices heading higher by May 19. The issue for US Oil Fund is that everyone knows when it will rebalance its portfolio from the June contract to July contract. The next rollover is between May 5 to May 8. The sun sets behind an idle pump jack near Karnes City, Texas. Demand for oil continues to fall due to the coronavirus outbreak. AP The fund holds only around 38,000 July WTI contracts traded on NYMEX and ICE, worth around $US710 million. The investors backing the fund may be proved right. But it's important to remember that the agreement between the Organisation of Petroleum Exporting Countries and Russia to cut production by 9.7 million barrels a day only comes into effect on May 1. While there are other technical issues at play for the US Oil Fund, like the yet to be approved issuing of 4 billion new shares and its ability to track the oil price, the bigger focus will be on the ability of the market to eradicate the oversupply of oil. Goldman Sachs said oil price volatility will remain "exceptionally high" in coming weeks, arguing that a finite amount of storage left to fill means that production will need to fall "sizeably". Price action is suggesting that massive cuts are needed now. The slump in the Brent oil price, the international benchmark, to below $US16 a barrel shows oversupply and a lack of storage is becoming a global problem – not just a US problem. The scale of the logistical chokepoint squeezing the life out of oil prices was underscored by a Bloomberg story on Royal Vopak, the world's largest independent storage company. The company has almost completely sold out of capacity at its terminals. But Goldman Sachs offers restrained optimism. It reckons the market "inflection" will play out in a matter of weeks, not months, with the market expected to be forced to balance by June. The risk is the market signal from low prices is ignored. A tweet from US President Donald Trump hinting at assistance for the US energy industry is good politics but very bad for those betting on a price rebound founded on a sharp cut to supply. The last thing the global oil market needs is governments tipping the scales in favour of their producers and avoiding the pain that needs to be shared collectively.
While I agree with several points in the article, the author commits a very typical mistake made even by market professionals. He states: In an oil market characterised by a super contango, where futures prices are higher than near term prices, the US Oil Fund is forced into monthly rollovers where it sells expiring contracts at a low – or negative – price and then buy futures at a higher price. That eats away at returns." This is complete bollocks. The assumption is that the fund NAV is computed off absolute prices in the underlying when it is actually based on total return. The fund each month sells the expiring contract and hence closes out a long position in the same contract and then enters a long in the next month. There is not a single cent lost in the roll-over, in fact, if traded intelligently, roll-overs can actually generate small yields to add to the performance by trading the basis spread profitably. But that is just an aside. Fact is that it does not matter what the absolute price differential is between different months' contracts. The return of the fund is based on the total return which is based on each expiration month's own underlying performance. So, for May contracts each sell generated PnL against the May longs. And each June long will function as basis for the June sells later on. Total return is never computed between the longs and shorts of different contracts/assets. Its like as if I sell my long in AMD and buy a share of Amazon and state that it is a horrible strategy because the price of AMD is a fraction of AMZN. AMD performance is measured by longs vs shorts in AMD, same with AMZN. The problematic features are manyfold but definitely it is not because of contango of oil. Utter nonsense.
The point is that the total return will underperform spot while oil is in contango. The author is absolutely correct in this.
How so? No, total return underperforms because of liquidity issues, prepositioning of other players because of the signaling effect and sheer size of the fund, the structure how it was set up, among other issues. Please would you explain why the fund should underperform spot specifically because of contango? And yes it must by definition underperform some due to management and admin fees (though above mentioned other issues contribute much more to the fund's underperformance"). But not because of contango.
Just imagine what happens if the futures curve remains constant for a few months. e.g. near month = 30, far month = 35. Every time you roll you are realizing a loss of $5.
I think what is happening is that USO is selling the old contract, which then just remains in cash. They can then purchase a new contract in the front month. I don't believe it loses money in this scenario, but admittedly, I may be wrong.
You get spot performance by getting oil in a storage paying all the fee associate with it. So "total return will underperform spot" is bollocks as ibanker will arb it away if this is the case.
This sounds like word games. I don't think most people would agree that "spot performance" includes storage costs. If this is some kind of industry standard definition, provide a citation. Regardless, the author's point about there being a drag on returns of the fund compared to a simple price-return of oil is absolutely correct.