By Sean Field and Mette M. High
In May 2020, the two main financial regulators in the United States (the SEC and CFTC) launched investigations into the multi-billion-dollar US Oil Fund (USO). Over the last decade, USO has attracted huge numbers of private household investors eager to invest in oil. Its shares are easily bought and sold on internet trading platforms and the share price closely tracks movements in the spot price of the West Texas Intermediate (WTI) crude oil benchmark. But USO has been a volatile investment proposition. Its share value dropped an unprecedented 80% between early-January and late-April 2020, moving from US $105 to US $17 in that period, while the net value of its underlying financial assets similarly fell by 80%, from about US $15 billion to US $3 billion, during this same period. The steep drop in USO value followed the historical fate of the WTI whose spot price entered negative territory for the first time in history on 20 April 2020, closing at -US $37.63 (see part 2 of this series).
Since the fall in the share price of USO, there have been numerous calls for investigations into how financial actors, such as USO, contributed to the unprecedented collapse in the spot price of WTI. While commentators were quick to point to the COVID-19 pandemic and the associated demand destruction, it is important to also recognise the impact of financial actors, such as USO, on the collapse in the spot price. Apart from investigating the financial dynamics that occurred at that time, investigators have raised concerns as to whether USO adequately disclosed to its shareholders the financial risks associated with investing in the fund, particularly when the USO fund managers made sudden major changes to the investment vehicle itself. These voices of concern included the Chair of the Commodity Futures Trading Commission (CFTC).
In this series, we share a few thoughts after negative oil prices became not just a possibility, but a reality. We show how the COVID-19 pandemic has highlighted the relationship between the physical and virtual dimensions of oil markets by exposing their physical limits, financial dynamics and how these intersect (see parts 1, 2, 3 and 4 of this series). In this part 5, we discuss one of WTI’s key financial market participants and its impact on oil markets. The controversy over USO exposes how oil has been repositioned from a commodity traded by specialist traders to a popularised household investment asset. The implication of funds like USO is that everyday investors collectively play a bigger role in determining US oil prices than ever before and, in turn, are exposed to the precarity of its price cycles and the sudden interventions made by fund managers.
ETFs and Oil Futures Markets
Since the mid-2000s, there has been a growing interest in exchange traded funds (ETFs). For household and institutional investors, the lure of ETFs is that they tap into the specialist knowledge of investment managers while harnessing the flexibility of shares that can be easily bought and sold, like stocks, via internet trading platforms.
ETFs were first introduced in the 1990s as index investment products, which means that the value of these ETFs moved up and down with the values of their underlying assets. By the mid-2000s, ETFs had gathered significant popularity among institutional and private investors as low-fee investment products with the indexing and diversification benefits of mutual funds, but were more easily bought and sold. Whereas most mutual funds required investors to stay invested for several months or years, ETFs could be bought or sold without contractual obligations or penalties. Online trading platforms tailored to private household investors strongly enhanced the convenience of buying and selling ETFs.
Commodity ETFs can be divided into two groups: funds that track a diversified basket of commodities (including oil) like the iShares S&P Goldman Sachs Commodity Index (SPGS-CI) and funds that track a specific commodity like USO that exclusively invests in WTI. Both of these ETFs started trading around the same time: USO began trading in April 2006 and SPGS-CI began trading as an ETF in July 2006. While ETFs had been around for several years, the popularity of these new ETFs in the mid-2000s was driven by greater private investor involvement in financial markets, greater interest in commodities as an asset class for investment, and greater access to user-friendly online trading platforms. Also, at this time, WTI specifically was on a sustained upward price trend that reached unusual highs right before the global financial crisis of 2007-2008.
Investors in USO aim to profit from rising oil prices. USO’s stated objective is for its share price to reflect “the daily changes… of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma” by owning near-expiring CME-NYMEX WTI contracts to buy oil. When CME-NYMEX WTI futures contracts expire, a promise to exchange oil becomes an obligation and the expiring contract price converges with the spot price (see part 3). This convergence holds futures market prices in tension with spot market prices, linking the contract price to the spot price at expiry.
Each CME-NYMEX WTI contract is for 1,000 barrels of oil. USO owns many tens of thousands of futures contracts to buy oil. This gives USO huge ownership of many millions of barrels of oil to be delivered at Cushing, Oklahoma, once these contracts expire (see part 2 of this series on Cushing).
The advantage of investing in futures contracts rather than physical commodities is two-fold. Firstly, approximating oil prices using CME-NYMEX WTI futures contracts alleviates USO’s fund managers of the expense and trouble of having to store and exchange physical quantities of oil. Secondly, investing in future contracts requires a fraction of the money required to trade physical commodities. Buyers and sellers of futures contracts deposit 10% of the total value of their futures contracts into a margin account with the commodity exchange house (CME-NYMEX) to secure ownership of their contracts. This leaves 90% of the investment money idle so that USO’s fund managers can invest it in financially secure investments (such as Treasury bonds) – effectively allowing the money to be invested twice.
USO ‘rolls’ its expiring futures contracts each month to avoid having to physically take delivery of the oil (see part 3 for a discussion on ‘rolling’).
To roll a futures contract, a trader creates a contract to cancel out the contract they own – a contract to ‘buy’ oil can be cancelled out by creating a contract to ‘sell’ oil for the same month. Then the trader buys a contract for the same commodity at a future date. When USO rolls its contracts, it exchanges thousands of contracts at a time – selling the soon-to-expire contracts and buying new contracts that expire further in the future.
Rolling can affect futures prices by bidding down the selling price of expiring futures contracts as they are dumped en masse, and by bidding up the price of future dated contracts as they are bought en masse. The ‘efficient market’ assumption is that these futures markets have enough buyers and sellers (“liquidity” in economic terminology) to absorb this massive and sudden buying/selling activity, leaving spot and futures prices unaffected by this ETF activity. Hotly debated in the scholarly literature, this assumption is difficult to assess because detailed trading data is unavailable for public or scholarly scrutiny.
However, what is known is that in early-April 2020 USO owned a quarter of all expiring CME-NYMEX WTI contracts. USO then rolled its WTI contracts (alongside other ETFs and big investors) just days before these contracts were set to expire. To avoid taking physical delivery of oil and with few counterparties with whom to exchange their futures contracts, USO (like others) offered lower and lower priced sell contracts to ‘roll’ their position before the expiry date.
As both the spot price for WTI and the value of USO shares collapsed, throngs of investors bought new USO shares hoping to ‘buy low’ and ‘sell high’ when oil prices were assumed to recover. But USO fund managers suspended the creation of new USO shares and rebalanced their portfolio away from only expiring WTI contracts to include WTI contracts expiring over several months in the future. These moves indicated that the fund was not just in financial distress, but actually on the verge of collapse.
Under these extraordinary physical supply circumstances of the COVID-19 pandemic (see part 2and part 3), USO contributed to the fall in oil prices in the days leading up to 20 April 2020. It is now understood that the convergence of the expiring futures contract price with the spot price, combined with the massive selling of futures contracts by futures market traders in the days and hours prior to expiry, exacerbated the drop of the WTI spot price, pushing it well into the negative as the two prices converged.
Valuing the Oil Patch
When the US Shale Revolution accelerated the race for oil in the mid-2000s, funds like USO invited investors to partake in the US oil rush. USO was designed to enable households to easily invest in and speculate on the spot price of WTI. However, when the price of WTI went negative and USO shares collapsed in value, it affected people’s savings in ways that had no historical precedent. And simultaneously, it seems that USO itself contributed to this decline through its large-scale futures market activities.
Sharing this blog post series with people we know in the hydrocarbon industry, one commented:
It is incredibly frustrating for the individuals who work on the physical supply side [the producers] to know that the markets can be manipulated by the ‘paper people’ who wouldn’t know a barrel of oil from a cup of dark cocoa.
This quote echoes similar statements that we have heard from many interlocutors in our field research across the industry. It reveals a strong and fundamental tension between purely financial futures market actors and people whose day-to-day livelihoods are connected to hydrocarbon production. For many interlocutors, it has become an acute and deepening disconnect where key decisions in financial markets shape the contours of not just the oil industry, but also our world. As oil travels from the wellhead to the delivery point in Cushing or other places, it pools with oil from other wells, but it also transforms into a financialised form that can be further abstracted into derivatives such as USO shares. As household and institutional investors make decisions to buy or sell, they are acting in and on our energy worlds – yet, with potentially little concern for what energy future they might be helping to bring into being.
To date, there have been no public announcements about the outcomes of investigations into USO or other WTI futures traders by the SEC or CFTC. Only one non-US firm is known to have been fined by its country’s regulatory authority following an investigation into the firm’s WTI futures trading activities and the losses incurred by its investors.
What seems certain, however, is that ETFs like USO and the financial markets they operate in are unlikely to go away anytime soon. This raises several questions, such as: What should the role of large financial traders be in determining current and expected energy commodity values? Should detailed information on their activities be made available for public and scholarly scrutiny? And to what extent, at this point in the financialisation of oil and other energy sources, can we pursue energy futures that do not necessarily align with the interest of the individual household and institutional investor?
Understanding energy finance and the actors that operate in these markets is essential for understanding how energy is valued, by whom and with what implications. We hope this series has shed light on the largely opaque and complex financial infrastructures, their material counterparts, and the oil flows that shape our collective energy worlds.