# Flood of oil ETF investors reshaping market, analysts say

## 'Massive' inflows cushioned oil price drop in early 2015, but could easily reverse

The crash in oil prices in late 2014 and early 2015 challenged long-standing assumptions about the workings of the oil market and prompted a number of tough questions. How will Saudi Arabia respond to low prices? Are US shale producers now setting the marginal price of a barrel of oil? And, above all, has the market reached the bottom yet?

In recent months, as prices have levelled off, some analysts have started asking another intriguing question: are exchange-traded funds (ETFs) propping up the price of oil? "ETFs introduce a new element to markets," wrote oil analyst Philip Verleger, owner and president of Colorado-based consultancy PKVerleger, in a March 30 report. "By throwing billions upon billions into oil, investors in these instruments – as well as investors in commodities – moderated the price decrease and extended the life and production of firms that are unprofitable at $50 per barrel (/bbl)." ### "Massive passives" The role of ETFs in oil price formation is a controversial topic and a recurring subject of political debate. Critics call oil ETFs "massive passives" and blame them for the historic run-up in crude oil prices during 2008 – claims that are vehemently rejected by ETF providers and many energy market participants. What's indisputable, though, is that oil ETFs have enjoyed a surge of popularity since the start of 2015, as investors have been drawn by low oil prices. The price of front-month West Texas Intermediate (WTI) crude oil futures traded on Chicago-based CME Group's Nymex exchange closed at$45.15/bbl on January 26, a drop of more than 60% from where the contract stood six months earlier. It has since staged a modest recovery, closing at $59.39/bbl on May 8. With oil ETFs experiencing heavy inflows, the funds accrued sizeable futures positions. For instance, the United States Oil Fund saw its holdings of WTI futures increase from less than 24,000 contracts at the start of the year to a peak of 66,791 contracts on March 20, the highest level since 2009 (see figure 1). Better known by its ticker symbol USO, the fund is managed by California-based ETF provider United States Commodity Funds. Mid-March appears to have been the high point for oil ETF investment this year. Back then, London-based investment firm ETF Securities estimated that ETF holdings totalled 170,000 to 180,000 WTI futures-equivalent contracts, a figure that may include over-the-counter swaps as well as futures. Each of those futures-equivalent contracts represents an underlying 1,000 barrels of crude oil. While that estimate represented only about 10% of open interest in Nymex WTI futures, it amounted to 25% to 30% of open interest in the first two months, where ETF holdings are concentrated, according to ETF Securities. Olivier Jakob, managing director of Switzerland-based research firm Petromatrix, says the "massive inflows" into ETFs helped stabilise oil prices in early 2015. "It's always difficult to attribute a price movement just to one market participant... but they did help in creating a floor under oil prices," Jakob says. At the time of writing, investor interest in oil ETFs had dropped substantially from its peak in March. By April 29, ETF Securities's estimates for the total holdings of all ETFs had dropped to 135,000 futures-equivalent contracts, or just over 20% of open interest in the first two months of Nymex WTI futures. And as of May 8, USO's holdings were down to 44,318 WTI contracts. But while investors' enthusiasm for ETFs has waned, the debate over the influence of oil ETFs has continued. In part, that is because they are one of the main targets of the US Commodity Futures Trading Commission (CFTC) as it seeks to rein in speculation in commodity derivatives. The CFTC is moving to finalise a rule introducing speculative position limits later this year, a new regulatory regime that is expected to clip the wings of ETFs and commodity investment in general (see box: Off limits). ### The ABCs of oil ETFs Commodity ETFs, which emerged in the 2000s, are traded on stock exchanges and provide a user-friendly way for retail investors to gain exposure to the price of crude oil and other commodities. The price of ETF shares generally rises and falls based on the value of the commodity or basket of commodities the ETF tracks, and the quantity of shares available expands and contracts as investors get in and get out. While some metal ETFs store actual physical stockpiles of the underlying commodity, most ETFs achieve their price-tracking effect by holding futures contracts. This means they must continually roll their futures holdings forward – in other words, as front-month contracts approach expiration, the ETFs must sell their positions and buy the next-month contract instead. USO is both the largest oil ETF in terms of assets and the oldest, having been launched in 2006. Since then, the market has grown to include a number of other oil ETFs, as well as exchange-traded notes (ETNs), which are structured differently but share the same objective of providing investors with exposure to oil (see table 1). Some ETFs allow investors to go short oil, but the majority of oil ETF investment is long. Since many ETF investors adopt a buy-to-hold strategy, this has fuelled the argument that funds such as USO are relentlessly driving up the oil market. In August 2009, Michael Masters, chief executive of Atlanta-based hedge fund Masters Capital Management, testified before the CFTC that commodity ETFs and ETNs – as well as commodity index swaps used by large institutional investors – deserved to be banned. The products had helped push the price of WTI to an intraday record high of more than$147/bbl in July the previous year, Masters said.

Not surprisingly, ETF providers disagree. There is "not the slightest shred of evidence" to support the theory that ETF investment drives increases in oil prices, says John Hyland, former chief financial officer of USO. Hyland says the notion of ETF investment driving up prices stems from a fundamental misunderstanding of commodity futures markets. Unlike in equities, where large purchases of shares by buy-to-hold investors can push up the price of those shares, commodity futures are a two-sided market with an equal number of longs and shorts, he argues. Moreover, buying by longs can actually draw more shorts into the market.

"You can have the supply of contracts increase to accommodate someone's desire to buy," says Hyland, who spoke shortly before he left USO on April 30. "So when I go and buy 50,000 more contracts... somebody brand-new was electing to be short 50,000 contracts. How come it's my buying them that's driving the price up? How come it's not their selling them that's driving the price down?"

### Supporting players

Despite such arguments, analysts at major banks say ETF investors were among the players supporting oil prices in early 2015. Jeffrey Currie, New York-based global head of commodity research at Goldman Sachs, offers several reasons why the bounce in prices was driven by investors. "It was broad-based across all commodities; that was one reason," Currie says. "Second, the fundamentals were very weak during that time period, which is why the market went back and revisited new lows. And then a third reason was that you could measure it. The inflows into ETFs were huge."

In particular, analysts note that buying by ETF investors propped up the front of the WTI futures curve relative to longer-dated futures. "Crude-linked ETF inflows have created froth at the front of the curve and buttressed, in particular, [the] WTI flat price," wrote Citi analysts in a research note on March 30. The analysts warned that a retreat by ETF investors could "exacerbate a downside price correction" in the second quarter of 2015.

Analysts say there is a good reason why ETF investors might choose to flee: the phenomenon known as negative roll yield. When a commodity futures market is in contango – the state in which front-month futures prices are lower than prices for longer-dated contracts – ETFs lose money from rolling their positions, since they are exchanging cheaper front-month contracts for more expensive next-month contracts.

WTI entered a state of contango in October last year, which continued at the time of writing. That has substantially eroded returns for investors that piled into oil ETFs in recent months. From the end of 2014 to April 28, the share price of USO actually lost 3.7% of its value, even though the price of front-month WTI rose by 7.1%.

Petromatrix's Jakob says the cost of negative roll yield will ultimately drive disgruntled investors away from oil ETFs – something that would quickly turn oil ETFs from a factor supporting the oil market into the opposite. "You can come to a situation where [investors] get fed up with contango rolling into their returns, and they drop their positions," he says. "And that can have a negative impact on prices."

Hyland rejects the idea that inflows into oil ETFs propped up prices in 2015, or anytime previously. "We've got 10 years of data that says it just doesn't work that way," he says. "If that were true in January and February, it should have shown up at other times in the past 10 years. This is what I like to refer to as cocktail chatter."

### The Verleger hypothesis

Of the analysts who have focused on oil ETFs in 2015, perhaps the most outspoken has been Verleger, a market veteran who helped create the WTI futures contract in the early 1980s and whose reports are still closely watched by industry participants.

Verleger argues that the impact of ETFs is far greater than momentary ups and downs in the price of front-month WTI. In particular, he believes the surge of oil ETF buying in the early months of 2015 enabled a significant amount of producer hedging, because producers have taken the opposite side of ETFs' long futures positions. In the first quarter of 2015, producers hedged between 100 and 200 million barrels of crude oil above what they could have hedged otherwise, thanks to inflows into ETFs and other investment funds, says Verleger.

That may be good for opportunistic producers that managed to put on hedges at just the right time. But it will ultimately weigh on prices, since those producers will keep pumping oil and adding to an already oversupplied market thanks to the protection offered by their hedges, Verleger says. "Producers, especially frackers, will not send thank-you notes to the ETFs," he wrote on March 30. "However, they should because the cashflow will help keep them in business. The funds will also slow or perhaps staunch the production decrease so eagerly awaited by those expecting higher prices."

Since demand for all that crude does not match the burgeoning supply, the excess crude goes into storage, according to Verleger's hypothesis. Data from the US Energy Information Administration (EIA) supports his argument: the amount of crude kept in the storage hub of Cushing, Oklahoma, hit an all-time record of 62.2 million bbl on April 27, up from less than 40 million bbl at the end of 2014, according to the EIA.

That stockpile represents a massive overhang of supply that poses a downside risk to crude prices, Verleger concludes. "A year from now and possibly for a decade or more, oil stored in US tanks will pose the greatest threat to global price stability," he wrote.

Hyland concedes that periods of inflows into oil ETFs do tend to coincide with crude piling up in storage. Over the 12 months ending in April 2015, the correlation between USO's holdings of WTI futures and US oil inventories was 0.866, a strong positive correlation, Hyland says. "So there may be something to Philip's suggestion that, at least over this last go-round, USO and other oil ETFs may be finding themselves on the opposite side of some of the holders of the increased inventory figures," he says.

Over the long run, though, Hyland notes that the correlation was much weaker – only 0.247 over the nine years since USO's launch in 2006. And he says there is still no proof that ETF inflows and outflows drive prices. "With oil ETFs, what you almost always see is the price changes first, and then the oil ETF buys [or] sells contracts, and not the other way around."

So should the CFTC rein in ETFs with its forthcoming rule on speculative position limits? Michael Cosgrove, a partner at New York-based proprietary trading firm Vectra Capital, thinks not. He says oil ETFs play a useful role in the market and should live on, even though they harm retail investors unaware of the risks of negative roll yield. "Long-only ETF holders don't realise what terrible investments they are buying," he says. "But as long as it's fully disclosed to them, and they decide to do it anyway, then let them do it."

Cosgrove notes that the US government has been stashing away hundreds of millions of barrels of crude oil since creating its Strategic Petroleum Reserve in 1975. ETF investors are effectively doing the same thing, he notes, but at their own personal expense. "The CFTC's position on oil ETFs is completely backwards," Cosgrove says. "It should be encouraging people to come in and pay for the building of commercial energy stocks. [ETF investors] should be given Medals of Honor, because they're burning up their net worth doing the work of Uncle Sam. And yet the CFTC is taking the position that they want to stop that."

### Off limits

The US Commodity Futures Trading Commission (CFTC) is seeking to finalise its rule on speculative position limits in commodity derivatives later this year. Backers of the rule argue that "massive passives" such as commodity-linked exchange-traded funds (ETFs) contribute to energy market volatility and must be reined in.

So what sort of impact would the CFTC's rule have on oil ETFs? The answer, perhaps surprisingly, is not very much.

Under the CFTC's proposed position limits rule, the most recent version of which dates back to November 2013, limits would be imposed on 28 core referenced futures contracts and economically equivalent over-the-counter swaps. The limits would apply to both spot and non-spot month contracts, but the formula for calculating them would be different. Spot-month limits would be set at no higher than 25% of estimated deliverable supply, while non-spot position limits would be set using a formula based on open interest – 10% of the first 25,000 contracts of open interest and 2.5% thereafter.

The biggest oil ETFs tend to hold benchmark West Texas Intermediate (WTI) crude oil futures, which are traded on Chicago-based CME Group's Nymex exchange. Under Nymex rules, as well as in the CFTC's proposed position limits rule, spot-month position limits only apply in the last three trading days before the contract expires.

But oil ETFs roll out of the front-month WTI contract before those last three days. For instance, the United States Oil Fund (USO) rolls out of the front-month contract and into the next-month contract two weeks before the expiry of the front-month contract. That means the CFTC's proposed spot-month limit is irrelevant to USO and other oil ETFs, says Sal Gilbertie, president of Teucrium Trading, a Vermont-based issuer of exchange-traded products linked to agricultural commodity prices.

"Nobody's playing in the spot month," Gilbertie says. "The issue with position limits is not the spot-month position limits. It's with the outer-month position limits."

But oil ETFs have little to fear from the CFTC's open interest-based formula for non-spot month limits – at least, not at current levels. John Hyland, the former chief financial officer of USO, estimates that the fund would hit the CFTC's proposed limit if its holdings reached about 100,000 WTI futures contracts. The fund approached that level in February 2009, when its holdings briefly exceeded 96,000 contracts, but since then it has never come close. Even during the surge in oil ETF investment in early 2015, total USO holdings only peaked at 66,791 contracts on March 20. So the CFTC's cap "would in fact set an upper limit, but it's not an upper limit that we're close to", says Hyland, who left his position at USO on April 30.

Market participants say the investor products that have the most to fear are large, diversified funds, such as the Pimco CommodityRealReturn Strategy Fund, which held $10 billion in assets at the end of April, or the PowerShares DB Commodity Index Tracking Fund, which held$3.1 billion. Such funds include smaller agricultural commodities such as sugar, for which the CFTC's limits are lower than for WTI. So even if larger funds had only a small percentage of their assets allocated to sugar, their large size would put them at risk of bumping up against the limits.

California-based asset manager Pimco did not respond to requests for comment, while Chicago-based Invesco PowerShares declined to comment. However, both companies acknowledge the risk posed by the CFTC's proposed rule. In Pimco's prospectus for its commodity fund, it says the CFTC's proposal "could adversely affect investors", since the fund may be forced to bail out of a commodity if its holdings approached a limit. Similarly, a prospectus from Chicago-based Invesco PowerShares says the new limits regime "may restrict the creation of baskets and the operation of the fund".

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