After the West Texas Intermediate (WTI) oil debacle last week, when prices traded all the way down to $0 and even minus $37 at one point, one would think retail investors would get the hint that something was not right with the oil market and would stop trading the United States Oil Fund ETF (USO) altogether. USO has been one of the most liquid and easiest ways for retail punters (oops, sorry, investors), to trade oil. The only problem is that the contract does not move the way it is expected to give the physical oil market's dislocations and inefficiencies.
Oil, like most commodities, can trade negative if there is simply just too much of it. Investors thinks their loss is limited at $0, but they are wrong, as prices can go negative and can be unlimited if the situation calls for it. This is what happened as brokers and clearing agents could not come back to the retail investors who lost all their capital and ask for more maintenance margin. They had to eat the loss at the end of settlement day, as per Interactive Brokers and Bank of China, to name a few.
As of Monday, they came in long about 62,000 contracts and ended the week at 200,000 despite the aggressive selloff. The extreme moves did not scare them, and fear and greed has driven them to buy even more. One can hardly blame them if they think Jay Powell & Co., the world's largest hedge fund, will come in and bail this ETF out, as the Powell-led Federal Reserve did with high yield and junk bonds, although this seems a remote possibility because oil is not the same.
The United States Oil Fund has changed its mandate about five times these past two weeks. Traditionally the oil ETF is meant to hold long the front-month contract, thus giving investors access to the spot price of oil. That is the entire purpose of this ETF.
Closer to the expiration, it sells the front month to roll the long exposure into the second month, a process called the "roll." In light of the ample supply of oil in the physical market right now, this roll is quite costly, and yet retail investors do not understand why the ETF will not rally even if oil rallies.
USO's diversification move
To avoid what happened last week, the trust said it would diversify its holdings in future months to avoid the spot exposure. After several changes, USO as of Monday said it would sell all its June WTI exposure before April 30 and keep a 30% weighting in July, 15% weightings in August, September, October and December and a 10% weighting in June 2021. It seems like the trust is making its strategy up as it goes along. It has become a discretionary hedge fund of its own. Investors no longer have exposure to spot, but rather some combination hybrid of the oil curve. One thing is certain: It will not be as volatile, but it also will not represent the best way to play oil.
This announcement put pressure on the June WTI contract on Monday, causing the spread between June and July to trade as wide as $7 to $9 per barrel from a level of $5 per barrel in the morning. This is just the retail players. Speculators and funds are also long the WTI via Nymex and ICE platforms. As of April 21 they added about 122 million barrels in the six most important futures and options contracts for the largest one-week increase since Christmas. Funds have been running a long of 307 million barrels, one of the largest net longs in the past three years. Everyone wants to buy oil because it has fallen so much and they think it is cheap. But that does not mean it cannot get cheaper.
The other side of the trade is the physical oil producers, U.S. shale and exploration-and-production companies that must physically go short the contract, looking to make a physical delivery. Shale companies can cut their production by up to 60% and still keep the well running optimally. However, if they cut more than 60% production the well then becomes uneconomical and needs to be shut. This is why producers would rather pump today and sell oil at uneconomical prices just to keep the well open for as long as possible; the decision to shut down a well is very costly, and to restart it is even more. However, they can only delay such shutdowns if oil prices recover fast.
Given the amount of oversupply in the oil market in April and May, prices need to stay lower to encourage them to shut production. About 9.7 million barrels per day of OPEC oil is set to come off, but even should demand recover in the middle of May as economies slowly reopen, the demand will be nowhere close to where it was back in January.
A sudden, unexpected shift
The S&P Dow Jones Commodity Index is another huge index that trades and tracks oil contracts. It also holds the front-month contract. It suddenly announced here on Tuesday that it will get out of its June contract exposure today. This is pressuring the June contract further along with the USO trust that has two more days to close out all its June longs. Adding in the physical market glut, all bets are off for June contract.
Investors seem to have become desensitized to the front-month contracts, but one should avoid trading the ETF altogether. Taking a step back, it is important to note that Brent crude's price, which is the global benchmark for oil prices as it is seaborne, is still trading around $20 to $24 a barrel; by contrast, most oil companies started the year assuming $55 a barrel and today are assuming $35 to $40 a barrel. We are still far from that. It will be a long journey, but companies likely will be cancelling all dividends and will curtail excess spending to reach a balance in the market.
