[Editor's Note: This article originally appeared on April 17, 2020.]
Big changes are coming to the world's largest oil ETF.
Last night, US Commodity Funds (USCF) announced that the United States Oil Fund LP (USO), a $3.9 billion fund that tracks the price of front-month oil futures, will shift 20% of its contracts to a later-dated contract instead. The change will take place today, April 17, and remain in place for the foreseeable future.
The move was a direct response to extraordinary conditions in the oil market and current regulatory requirements, said the issuer in the SEC filing announcing the change.
The shift "may impact the performance of USO," added USCF, which stated that "as a result of these changes, USO may not be able to meet its investment objective" of tracking the daily price of front-month oil futures.
How USO Works, Then & Now
Typically USO holds near-month NYMEX and ICE futures of West Texas Intermediate (WTI) crude oil, also known as light sweet crude oil. Two weeks before the front-month contract is set to expire, the fund managers sell the expiring contract and buy the next month's one, in a process known as "rolling."
USO just completed its roll period, meaning the fund is currently invested in the June 2020 NYMEX WTI contract, rather than the May one.
However, as a result of the announced change, USO will now move 20% of its contracts to the July 2020 contract instead. It will continue to maintain this "second-month" contract position for the foreseeable future, rolling that 20% to the third-month contract at the usual roll time.
The remaining 80% of USO's portfolio is unaffected and will remain in the front-month contract.
Contango Eats Into USO Returns
The portfolio adjustment addresses a tangle of interrelated factors, the first being the plummeting price of oil. Since March 2, the spot price of WTI crude oil has fallen from $46.78/barrel to below $20/barrel on April 16.
As oil prices slump, the related futures market has entered steep contango. Essentially, contango means that futures contracts with farther-out expiration dates cost more to buy than ones with nearer dates. (Read: "Why You Can't Buy Spot Oil: A Guide To Contango & Backwardation.")
As of the morning of April 17, there was a $6.42 difference between the price of the May and June 2020 NYMEX WTI contracts, meaning any investor looking to roll their position between the two would need to eat a 32% difference.
For a fund like USO, which maintains a constant futures position that it must roll from month to month, that sort of roll differential can quickly erode its returns—or, in this case, exacerbate its losses.
Meanwhile, there was only a $3.95 difference in price between the June and July 2020 NYMEX WTI contracts, leading to a roll cost of just 15%.
Massive Inflows Mean Regulatory Snags
But falling oil prices have had another impact for USO: massive inflows, likely from investors betting on a rebound in crude oil prices. (Read: "Oil ETFs For The Coming Rebound.")
Since March 1, a whopping $3.4 billion of new net cash has entered the fund, with $725 million flowing in just this week alone:
Source: ETF.com; data as of April 17, 2020
The problem is, the more money that enters USO, the more futures contracts the fund must purchase in order to keep up with demand. Yet in 2011, the Commodity Futures Trading Commission imposed position limits such that no one investor can hold more than 25% of the deliverable supply of a given futures contract.
As of April. 16, USO held 148,264 June 2020 WTI crude oil NYMEX contracts—or roughly 28% of the total open interest for that contract. From a regulatory standpoint, something had to be done.
By swapping 20% of its portfolio to another contract, USO brings its total position in the June 2020 contract down to 22% of the total open interest, which is within the allowable regulatory limits.
What Happens Next For USO
The structural change should solve USO's immediate challenges. But if oil prices continue to fall, or if USO continues to see massive inflows, future portfolio adjustments may become necessary.
The fund's prospectus gives it the leeway to invest in a range of other instruments, if those instruments can help achieve "greater liquidity or to execute transactions with more favorable pricing," said USCF in the SEC filing.
These include not just second-month oil futures, but other types of petroleum-product futures too, as well as options, swaps and forwards based on oil futures and related fuels and indexes.
Contact Lara Crigger at [email protected]