The WTI May 2020 futures contract hit the headlines by trading at minus 40 USD yesterday. Structured investment products were the driving force as financial investors are not interested in holding the physical commodity. They realized too late that nobody else was willing to take delivery as U.S. storage facilities are running at full capacity. The resulting turbulences have real effects on the economy and jobs. Therefore, the raison d’etre for structured products on selected commodities is more than questionable.
One of the critical issues with structured products on commodities is that they do not buy and hold physical assets. Instead, they hold financial futures contracts and roll them. That becomes a problem if a supply and demand imbalance occurs between the financial and physical components. That happened on April 20th, 2020 as the physical market was not able to take delivery from the nearest future contract. The USO was among the most actively traded ETFs on Monday. Investors wanted to buy the oil dip as they saw WTI crude quoted in single digits throughout financial media. The problem is that most commodity-linked ETF investors do not understand what they are buying. The USO product rolled its exposure predominately into the June 2020 future last week. Therefore, USO investors were buying WTI crude oil at roughly USD 22 and not the single-digit price shown throughout financial media.
The worst-case scenario is if an ETF has exposure to a contract that turns negative. The product becomes a liability from that point on. Consequently, the liquidity providing party, most often a bank’s trading desk, will have to unwind its hedge and sell all future contracts that generate the ETF’s exposure to the linked commodity. This fact has major implications in the oil market today. The USO alone held, as of last Friday, more than a quarter of the total open interest in the June 2020 contract on the CME. Other WTI-linked ETFs and structured products increase that share. This is huge by relative and absolute measures. A negative WTI June 2020 contract is a black swan and an unlikely scenario. However, it is not impossible as we witnessed yesterday. That would trigger a spiral of liquidations in margin accounts that trade futures, which has further negative implications across other asset classes.
There is a compelling investment case for crude oil after reaching a multi-decade low in absolute terms. Regardless of the valuation approach, crude oil is cheap from a historical perspective. The global economy will pick up sooner or later and as will demand for oil. Baron Rothschild, an 18th-century British nobleman, is credited with saying that “the time to buy is when there’s blood in the streets.” Sentiment in the oil market turned blood red on April 20th, 2020. WTI crude is an attractive long-term investment from a contrarian perspective. However, the choice of instruments is not trivial. At the time of this write-up, the December 2022 and December 2026 future contracts trade at 38 and 46 U.S. Dollars, respectively. That’s far higher than the nearest futures or spot price. Buying the dip in WTI with a margin of safety involves choosing the right instruments. That is either investing through medium-term crude futures contracts, which are not overcrowded, or ETFs that generate their exposure with similar medium-term contracts. The devil is in the details of the legal documentation.
Yesterday’s price action in the May 2020 WTI contract is a vital argument against an uncritical application of the modern passive investing approach. Liquidity can distort historical price characteristics and correlations. Moreover, especially commodity investors must know the mechanics of their structured investment vehicle even if it appears trivial. That involves studying and understanding the legal ETF documents before investing.