Don’t Throw Away The Instructions!
Here’s a quick summary of what’s been going on in oil this week. The pandemic has crushed the demand for oil, producers worldwide are pumping record amounts of supply, there’s nowhere to put it because storage facilities are filling up, and it’s almost impossible to turn off existing wells so more supply is coming soon.
The byproduct of this mayhem sent the price for West Texas Intermediate oil below zero on Monday to close at -$37.63. While this certainly caused a great deal of panic, others viewed it as an opportunity.
The United States Oil Fund (ticker: USO) attempts to track the daily price movements of U.S. crude oil. On Thursday, it was the 26th most traded position on Robinhood, which is a service that offers free trading and is popular with Millennials.
However, those that failed to read the instruction manual may be in for a “crude awakening.” But before we explain why, let’s first explain the ways individuals can invest in commodities to better understand why USO garnered so much interest.
There are four ways to invest in commodities. The first is direct ownership. This is relatively easy for gold and silver, but not for others that are perishable like corn or deadly like uranium. Expenses like insurance, security against theft, brokering, and transportation eat into returns over time.
For all intents and purposes, oil cannot be owned directly by individuals. It is highly flammable, smells bad, and subject to strict regulations. Companies do exist that specialize in storing oil, but they tend to charge a lot and have minimums that are far out of reach for most speculators.
The second way is through futures contracts. Here, commodities are transacted through agreements between producers and major consumers of goods that stipulate the price paid and the time of delivery. The futures market offers consistency (contracts look the same) and liquidity (ease of buying and selling).
Futures also allow speculators to bet on commodities without having to take physical delivery. If a speculator wanted to bet that oil will rise, she could enter into a contract to buy oil at a specific price and date. If oil increased in price prior to expiration, she could sell this contract for a profit and never have to take delivery of the oil.
While this solves the challenge of owning oil directly, the futures market is quirky and requires extensive experience to trade in it. Futures are also designed for companies to transact, so contracts are large. For example, a single gold futures contract requires a commitment to buy 100 ounces of gold. At today’s prices, that’s around $175,0001. The contract size for oil on the NYMEX is 1,000 barrels. While this a smaller commitment, it’s still well out of reach for many individuals.
The third way is using Exchange Traded Funds (ETF). This is a marketable security that tracks an index or a basket of stocks, bonds, and/or commodities. For example, a gold ETF owns bars of gold and then issues shares that represent a percentage ownership of the gold being stored in the vault. These shares are then bought and sold in the same manner as equities on major stocks exchanges.
The benefit to ETFs and other exchange traded products is the ease of ownership and ability to buy/sell quickly. The downside is that ETFs charge a fee called an “expense ratio” to facilitate this ease of ownership. They also qualify as commodity pools to the Internal Revenue Service (IRS), so investors will receive a K-1 for taxes.
The fourth way is to invest in companies that produce or transact in the commodity. Those seeking exposure to oil without paying storage costs or an ETF expense ratio could buy stocks of companies that drill for oil. However, stock ownership exposes an investor to “company risk.”
For example, if an oil driller incurred debt to expand operations but could no longer support the interest payments, an investor is now at risk of losing their money if the company files for bankruptcy (even if oil prices continued to rise higher).
Of these options, ETFs tend to dominate with individual investors due to the familiarity and ease of trading (they trade like stocks).
Under The Hood
USO is an ETF and one of the most popular vehicles out there for individual investors looking to add oil to their portfolio. While the fund has done a decent job at tracking U.S. oil over the span of a few days/weeks, it has been a perennial money-loser for decades and is not suited for long-term investors. This is because USO and most other ETFs that market themselves as a way to get exposure to oil don’t actually own oil.
As discussed, oil is difficult and expensive to store, so oil ETFs own futures contracts instead. Meaning, when an investor buys USO, they own a fractional share on a futures contract rather than barrels of oil.
There is a big difference between a barrel of oil and a futures contract. Oil just sits there until consumed, whereas a contract is the right to buy and sell over a finite time period. Once that contract expires, the transaction gets executed and goes away.
For example, if a speculator bought a futures contract for oil that expires in June for $20 today, it would cost him $20,000 ($20 per contract on 1,000 barrels). If oil rose to $35, that contract could be sold at expiration for $35,000 for a $15,000 profit. If the speculator wanted to keep the trade going, he would need to take his $35,000 and buy a new futures contract that expired in July. This process is called “rolling.”
Since USO buys futures contracts, the fund must also roll its contracts to keep the money in the fund invested. The problem is that costs associated with buying and selling so many contracts combined with mechanics of these contract has led this fund to stray far away from the price of oil.
In fact, USO is down 78% year-to-date1. It has also lost over 96% of its value since it began trading in April 2006 (chart below) due to its inability to function properly. Despite this, speculators added $3 billion to the fund's total asset base in the last six weeks. USO was recently at just $1 billion, so the fund has quadrupled in size2. This leads me to believe that a lot of buyers did not read the instruction manual first.
The Bottom Line
It’s understandable to see why so many saw an opportunity when oil went negative this week. Few industries survive by paying their customers to buy their products. Oil is also pretty important to the global economy, so demand will likely recover once the world economy turns back on.
The logical next step would be to find a product that allowed an investor to act fast to gain exposure to oil before the price corrected. USO is the largest oil ETF, and ETFs trade like stocks, so it’s unsurprising to see so many billions rush into the fund.
It also makes sense that an investor would assume that by buying an oil ETF, they would own oil. But that’s not how it always works in financial services. A good rule of thumb is that any product offering access to markets that are difficult to access usually doesn’t work as expected. Oil is most certainly one of those markets.
Lastly, for those who want to enter the futures markets directly, there are professionals out there who do understand this stuff really well. It’s their job to trade these markets and know every detail about futures contracts. By the time most individual investors think to make a move, they already have (some are even known to install monitors in bathrooms, so their eyes are on markets at all times). The point here is to never forget who is on the other side of the trade and why they are there.
The bottom line is that USO became so popular because it looks easy, but investors should always read the instruction manual first. Don’t jump into any investment product unless you or your financial advisor has a thorough understanding of how it works.
Mike Sorrentino, CFA
Chief Investment Officer
Three Key Points
- West Texas Intermediate oil fell below zero on Monday to close at -$37.63.
- ETFs are a popular way to invest in oil markets.
- Investors in these products should read the instruction manual first.
1 Bloomberg, as of 4/23/2020
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