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Difficulty: Nightmare
1) WTI price crashed to NEGATIVE $37.63 on 20 Apr 2020
2) Due to scarce storage space + exacerbated by investors who wanted to buy oil (or “long” oil, in finance-speak) earlier in May via the USO ETF
3) Instead of the USO ETF (which is based on oil futures and has a negative decay), investors can look at oil stock ETFs such as XLE US and XOP US.
The oil price went negative in Apr
Something interesting happened in the oil markets this week. For the first time ever, oil futures traded with a negative price.
For many, this was something unfathomable and I received multiple queries on how to profit from this. After all, wouldn’t oil have to revert back to a positive price, resulting in a sure gain for investors looking to buy negatively priced oil?
The answer is not so straightforward. First, we need to understand what a futures contract on WTI entails.
So why did the oil price become negative?
Physical delivery and scarce storage space. If you bought into a WTI Futures Contract for May delivery and held it to maturity, you would be obliged to take delivery of the physical crude oil between 1-31 May 2020.
As storage space for oil was getting scarce given prior months of oversupply, many owners of the May Contract had no intention to take physical delivery. As a result, they had no choice but to unwind the May contract by 21 April, the last trading day of this contract.
The buyer/seller mismatch got to such an extreme point that owners of the May contract had to pay others to take over the contract, resulting in a negative futures price.
This was exacerbated by punters and retail investors who wanted to buy or “long” oil earlier in May, and had bought the USO ETF . They thought that oil prices had hit an unsustainable low level and were hoping to make a quick buck when oil price rebounds from here. To do this, these investors bought into ETFs/ETNs tracking crude oil futures such at the United States Oil Fund (USO US).
More on the USO ETF and how it exacerbated the situation
Many investors buy into the USO ETF thinking that they will benefit if the nearest oil futures contract price increases in value. While this is one factor that drives returns, there is a commonly overlooked factor that also drives return – the roll yield.
What is the roll yield? Roll yield is the amount of return generated in the futures market after an investor sells a short-term contract and buys a long-term contract (i.e. rolls a short-term contract into a longer-term contract).
When is the roll yield negative? If the short-term contract price is less than the long-term contract price. I.e. the investor (or an ETF) sells the short-term contract at a lower price and buy the long-term contract at a higher price. In finance-speak, the roll yield is negative when the futures curve (see below) is upward-sloping.
So what if the roll yield is negative? For the ETFs with roll yield, you can think of negative roll yield as a sort of decay. If the futures curve does not move, then the ETF will decrease in value with time.
Only some ETFs have roll yield. How to tell which ETFs have roll yield? It depends on what the ETF’s underlying positions are. If they are just stocks, then the ETF doesn’t have a roll yield. If the underlying is made up of futures contracts (like WTI futures), then that ETF will have a roll yield.
Why can’t these ETFs just NOT roll their contracts? These futures ETFs have to roll their contracts, because they do not want to take physical delivery of their contract. For instance, if the May futures contract expires in their hands, the ETF has to take physical delivery of the oil.
The USO ETF has a roll yield: USO purchases the nearest crude oil futures contract as its underlying. As the nearest futures contract approaches maturity, USO has to sell the nearest month’s contract and buy into the subsequent month’s futures contract (rolling the futures).
As many retail investors bought the USO ETF earlier in May, the USO ETF had to buy more of their underlying for that month (the May contract). As such, we saw further selling pressure on the May maturity WTI contract due to the rolling over to the June maturity contract by the USO ETF.
Using the below chart as an example, imagine the ETF is rolling its futures contacts from May to June, the ETF will have to sell the May contract at minus $37.63 and buy the June contract at $20.43, paying a total outlay of $58.06.
Assuming no change to the futures contract prices as June approaches, the ETF then has to sell the June contract at $20.43 to buy the July contract at $26.28, paying an outlay of $5.85.
Negative roll yield chips away at the value of the USO ETF. This can be very costly for people who own ETFs. In some extreme cases, the negative roll yield can lead up to a 50% decay in the USO ETF value per month. Frankly, you would likely be better off taking your chances on the roulette table.
Of course, roll yield can be positive as well. If the oil futures curve is negatively sloping, the ETF will have a positive roll yield, which is beneficial to the ETF owner.
If not the USO ETF, how can we profit from current US oil markets then?
The best way yet unfeasible for most investors is to own a oil tanker, buy the closest WTI oil futures contract with the intention to take physical delivery of the oil, while concurrently selling a WTI oil futures contract expiring in two to three months time with the intention to physically deliver back the oil at a much higher price.
Alternatively, if you think that oil stocks have been oversold and you think that we will see a recovery in the sector soon, you can buy into an ETF that tracks an energy sector stock index.
These ETFs have stocks as their underlying and therefore do not have roll yield.
Some of the more notable stock-based oil ETFs include The Energy Select Sector SPDR® Fund (XLE US) and SPDR® S&P® Oil & Gas Exploration & Production ETF (XOP US).
Since these ETFs have oil stocks instead of oil futures as their underlying, they are not as “direct” as an investment in oil prices, compared to the USO ETF.
However, one big benefit is that these oil stock ETFs do not have the (currently negative) roll yield while still providing investors with a relatively high correlation to oil prices.
21st May update: USO changes ETF construction methodology
#Update to USO ETF construction methodology: As a result of the negative priced oil event and super steep oil futures curve that leads to a very negative roll yield, the USO ETF has now amended the methodology it uses to track WTI crude prices.
Instead of buying the nearest dated crude contracts, the USO ETF now
“may invest in the above described crude oil futures contracts on the NYMEX and ICE Futures in any month available or in varying percentages or invest in any other of the permitted investments described below and in its prospectus, without further disclosure.”
Which means that instead of holding 100% Jun contracts, the USO ETF can now hold 10% Jun, 10% Jul, 10% Aug… contracts. This gives them more room to reduce or spread the impact of another negative oil price event.
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