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Oil price collapse has severe effect on oil ETPs

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The WTI oil price collapse to almost minus USD40 earlier this week has had a widespread effect but none has suffered as much as the United States Oil Fund LP USO, an ETP that started the week with USD4 billion in assets, that tracks the oil futures markets and gives investors direct access to the oil price.

USO was down over 40 per cent by Tuesday and suspended new creations as it had actually run out of preregistered shares to hand over to authorised participants.

USO’s loss over the course of its existence is over 93 per cent. Its performance table is a sea of negative figures but despite that, a chance to profit from the chaotic oil price saw investors rush into the ETP, putting in more than half a billion in new money earlier this week. Now the ETP has had to avoid worse losses by moving out of the June WTI futures contract to later-dated contracts or other energy-based derivatives.

ETF Express’s sister title, Hedgeweek, reported that London-based oil specialist Pierre Andurand, head of commodities-focused fund manager Andurand Capital Management, was cautioning of “crazy losses” as oil markets continued to suffer unprecedented shocks, warning: “Be very careful out there.”

Andurand flagged up the potential impact of tumbling prices on oil ETFs in a series of tweets on Monday and Tuesday, after prices for the May futures contract on West Texas Intermediate – the US benchmark – collapsed into negative price territory for the first time ever.

“Wondering what would happen to USO and other oil ETFs that mainly hold June WTI if June WTI goes negative before the roll?” he tweeted on Tuesday.    

Allan Lane, founder of ETF model portfolio firm Algo-Chain and ETF veteran comments: “The extreme collapse in the spot price of oil, has been accompanied by unprecedented drops in a number of futures contracts, such as the May and June 2020 WTI contracts – which  provides the foundation for a number of Exchange Traded Notes, ETFs, with or without leverage.  

“It’s not surprising to see that confusion abounds as the May contract rolled off while the June contract rolled on, one minute the nearest contract was trading at minus USD40, then when you looked a couple of days later it was trading at plus USD11.”

Lane explains that futures contracts always display this complexity when contract prices switch, commenting that this time it is off the scale and the ‘triple leveraged products have caused carnage for those the wrong way round’.

However, Lane concludes: “As a final note, it’s probably worth mentioning, these ETNs, with their lack of diversification, do not qualify as ETFs.  Nonetheless, I won’t be surprised to hear a number of protagonists suggest this is another example of the ETF eco-system being built on sand, but that’s why we recommend that most investors should stick to plain ‘Stocks & Bonds’ ETFs, where diversification is your friend.”

Meanwhile, DWS has published a note on what the WTI oil price collapse means for the sector, writing that the price drop partly reflected the short-sightedness of some market participants with regard to physical storage constraints.

It also highlights the continuing pressures on oil prices, despite the recent agreement among OPEC+ countries and other oil producers to cut production.

However, looking forward, DWS believes that, while there might well be further temporary market dislocations, the end result is likely to be a healthier set of oil-market dynamics.

DWS does not believe that oil is the next asset where negative prices become the new normal, writing: “To be sure, there might well be further temporary market dislocations like the ones we saw on Monday.”

With oil mostly traded via futures contracts expiring each month, when a future expires, the buyer has to take physical delivery of the asset from the seller shortly thereafter. Crucially, delivery has to take place at a delivery point specified in the contract and for WTI there was simply no more room at their Cushing, Oklahoma-based facility.

As a result, on Monday, prices for the shortly expiring WTI contract fell below zero for the first time ever and that meant that producers or traders were essentially paying other market participants to take the oil off their hands on the next delivery date. 

Physical storage capacity for oil is limited so only those who had leased spare storage capacity could buy the contracts. 

DWS comments that these market participants will probably make a killing: they are likely to be able to sell the oil bought at minus USD30 or USD40 for about USD20, which is where the next WTI futures contract (June contract) is currently trading.

The firm writes that in the meantime, the oil-price decline is likely to exert further downward pressure on inflation and inflation expectations. 

“This is consistent with our view that interest rates will remain low for quite a while. Commodity currencies, such as the Russian ruble, are likely to remain under pressure. As far as bonds are concerned, oil-exporting countries and the US high-yield sector appear especially exposed. Keep in mind, however, that US high-yield spreads are already much wider than during the oil-price decline in late 2015 and early 2016.”

DWS writes that for most equity markets, the direct implications appear more modest. “In 2019, the energy sector accounted for only about 4 per cent of the earnings of the S&P 500 companies, and 6 per cent for those in the MSCI AC World Index. Of course, some countries have larger energy sectors, notably certain emerging markets, such as Russia, but also the UK. 

“More significant, though, may be the indirect effects on economic growth, as oil companies cut capital expenditure further. This will hurt oil-service companies and equipment makers. US and Canadian banks, with loan exposure to the sector, are also at risk. Last but not least, the psychological effects on consumers, businesses and investors should not be underestimated. For most industrial countries, you would normally expect lower oil prices to be taken as good news, as they mean lower gasoline prices for consumers and lower input costs for many producers. But at a time when so many are stuck at home, this oil-price collapse is unlikely to provide much of a sentiment boost,” DWS writes.

Commenting on the collapse in the oil price and its likely effect on UK inflation, Laura Suter, personal finance analyst at investment platform AJ Bell, comments: “Even before the recent capitulation, the price of oil was on the slide in March and this dragged inflation down slightly from February’s 1.7 per cent to 1.5 per cent. Oil prices have a massive impact on the UK’s inflation rate and with prices at the pump and home energy costs getting cheaper we’d expect this trend to continue for the next couple of months.

“What’s more, with retailers having to shut their doors we’re seeing more and more offer discounts to shoppers to move their buying online. In particular clothing and department stores have been hit, as people don’t need new outfits to sit on their sofa all day and are delaying large purchases amid worries about where the economy is headed. One area of slight upward pressure was from alcohol and tobacco, partly because we’re drinking at home more and partly because tobacco duty increased in March following the Budget.

“Savers will welcome the news of a drop in inflation, as they have been pummelled with two further falls in the Bank of England base rate this year and a multitude of cuts to interest rates on savings accounts. However, it remains the case that no easy-access savings account meets the level of inflation, but savers who are willing to lock their money up for a year can at least keep pace with inflation.

“The ONS also faces a challenge to accurately record inflation during the current crisis. Not only is it harder to get hold of pricing information with so many retailers closed, but the way we shop and what we’re buying has vastly changed, meaning the inclusion of items such as holidays, travel and eating out in the ‘inflation basket’ no longer represents what we’re actually spending our money on. How much this matters depends on how long the crisis lasts and whether our spending habits are dramatically altered for the remainder of the year – or beyond,” Suter concludes.

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