Regulators on notice as ETPs exacerbate volatility in oil markets

Tom Eckett

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Regulators are becoming increasingly concerned about the impact exchange-traded products (ETPs) are having on the oil market following widespread moves to longer-dated futures contracts.

ETPs offering exposure to oil have seen their assets balloon this year as investors sought to take advantage of the collapse in prices.

According to data from ETF Action, flows into US-listed oil ETPs this year ($7.5bn) have exceeded the total assets under management ($6.4bn) of these same products, as of 21 April, highlighting just how bullish investors have been about a bounce in prices.

Instead of bouncing however, oil prices plunged into negative territory for the first time in history with West Texas Intermediate (WTI) trading as low as $-40 a barrel on 20 April amid storage issues for May futures contract holders.

Despite the turmoil, investors continued to pile into oil ETPs with the $3.6bn United States Oil Fund (USO), the world’s largest oil ETP, filing with the Securities and Exchange Commission to create an extra four million shares in order to meet demand.

Due to the popularity of USO, in particular, oil ETPs have been increasing their share of the front-end futures market. According to data from Bloomberg, at one point, USO held between 25% and 30% of June crude futures contracts.

However, as concerns grew that June WTI contracts could also hit $0 a barrel but this time before ETPs rolled over onto the next month, USO changed the investment strategy by increasing its exposure to longer-dated futures contracts.

This began on 17 April when USO filed with the SEC to shift 20% of its assets to second-month futures contracts. Amid further oil market turmoil, the investment strategy was shifted to invest “in any month available or in varying percentages”.

The process culminated on 27 April when USO announced it would be rolling the entirety of its June contracts 8 days early and have 10% of its portfolio in June 2021 futures contracts due to limits imposed by regulators. It is important to remember USO only bought front-month contracts before collapse in oil prices.

The changes highlight concerns from regulators and the global futures trading hub, the CME Group in Chicago, about the impact the size of USO’s positions in front-month futures contracts can have on the market. According to the Financial Times, last week the CME imposed limits on the amount of front-month contracts USO can hold; 78,000 in July, 50,000 in August and 35,000 in September.

USO is not the only oil ETP to shift away from June contracts. The $539m Samsung S&P GSCI Crude Oil ER Futures ETP (3175), the world’s fifth largest oil ETP, announced on 21 April it would be rolling the entirety of its June contracts to September in response to “the current unusual and extreme market circumstances”.

Changes have also been made at an index provider level. On 24 April Bloomberg announced plans to advance the roll of the July contracts to September across its Bloomberg Commodity Index (BCOM) series following consultation with investors, market makers and hedge providers.

The roll, which will impact some of the world's largest oil ETPs such as the $1.3bn WisdomTree WTI Crude Oil ETC (CRUD), will take place over the five days beginning on 7 May "in light of unprecedented and exigent market circumstances".

Bloomberg added: "During this process, we remain in touch with relevant regulatory authorities."

S&P Dow Jones Indices also announced plans to roll all its WTI contracts to July on 28 April.

These decisions to flee June contracts have had a huge impact on WTI spot prices. WTI fell 28% to $12.3 a barrel on 27 April amid the USO’s decision to sell all of its June futures contracts. According to Reuters, USO’s June contract holdings accounted for 11% of the market.

The moves highlight how concerned market participants are about the outlook for oil prices in the short-term. If the June contract does hit $0 a barrel, any oil ETP with exposure to that month will see returns wiped out entirely.

Furthermore, the changes in investment strategies by ETF issuers and index providers place the viability of many of the commodity indices into the spotlight.

The majority of traditional indices suffer from what is known as ‘negative roll yield’ which occurs when a market is in contango. When markets are in "super" contango, like the one today, there is an increased cost to rolling futures contracts.

In response to this issue, market participants offered new methods of offering exposure to the oil futures market. UBS Asset Management, for example, launched the UBS Bloomberg CMCI WTI Crude index in 2007, which implements daily rolling, in order avoid “the costly position of ‘buying high, selling low’ each time a future is rolled”.

As Kenneth Lamont, senior ETF analyst at Morningstar, said: “If we have a situation in which ETP providers are intervening on behalf of their investors – which for the record I think they should be – then perhaps when the dust settles we should all be having a discussion about whether these indices are robust enough.”

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