Oil Market’s Crisis Spreads to Individual Investors

Many analysts caution that complicated products like the U.S. Oil ETF are too risky for retail investors

Updated April 21, 2020 4:42 pm ET

The collapse in crude prices is creating mounting losses for ordinary investors, a sign that the energy crisis is starting to ripple beyond the oil patch.

Individual investors have piled into risky products like the United States Oil Fund, a popular exchange-traded fund designed to track the price of crude, despite warnings that such products are unsuitable for inexperienced traders.

Hundreds of millions of dollars have flowed into the fund in recent days, even with its price collapsing.

Investors are trying to wager on an oil-market recovery after lockdown measures to stop the coronavirus are lifted.

But oil continues dropping, with factories shut and airplanes and motorists unable to travel. The benchmark U.S. crude futures contract for delivery in June tumbled 43% to $11.57 a barrel Tuesday, its lowest close in 21 years. The contract for delivery next month, meanwhile, rebounded into positive territory after plunging below $0 Monday. —a first in oil-futures market data going back to 1983.

“I’m either going to get my ass handed to me or I’m going to be really smart,” Sean Douglas, a 36-year-old entrepreneur in Raleigh, N.C., said. “I’m going to just ride it all the way.” He invested about $1,000 in the ETF this month. Its price fell 25% to $2.81 on Tuesday, bringing its drop in the past week to 41%.

The energy-market turmoil contributed to a Tuesday slide in stocks and adds to pressure on oil ETFs. Many analysts have warned against individuals owning the products for years because of losses suffered during past periods of market stress, including the financial crisis. Some use borrowed money to amplify returns, a process that can magnify losses when things sour.

The U.S. Oil Fund’s operator, United States Commodity Funds LLC, said it has issued all registered shares and suspended the ability of purchasers to buy new creation baskets. Such baskets hold the fund’s oil futures. The move will essentially make the ETF a closed-end fund with a fixed number of shares for now. That could make it even more volatile, because its price can now diverge from the fund’s total asset value.

Analysts said traders trying to bet against the fund by borrowing shares and then buying them back at a lower price have added to the chaos.

John Love, president and chief executive of USCF, said Monday that the firm continues to monitor market dynamics. The firm declined to comment Tuesday.

In another sign of pressure on the sector,Barclays PLC said recently it is suspending sales and redeeming its iPath Series B S&P GSCI Crude Oil ETN, a smaller, risky product also used to wager on oil.

The trend highlights the risks of trading commodities, which are tied to real-world supply and demand and involve physical delivery of raw materials. Many analysts caution that retail investors shouldn’t own complicated oil products like the U.S. Oil ETF for that reason.

“There’s definitely a certain percentage of the customers that have no idea what’s going to happen to them,” said Robert Yawger, director of the futures division at Mizuho Securities USA. “They have no idea the slaughter they’re getting into.”

Such funds are one of the easiest ways ordinary investors can own commodities since trading futures through a broker is cumbersome. But analysts say it is important to understand the products involved. Assets managed by 16 oil and gas ETFs tracked by FactSet swelled from about $4.8 billion in late February to nearly $11 billion on Friday. Much of that growth came from the U.S. Oil ETF, by far the largest of the group.

“So much money has been chasing something that turns out to be so very wrong,” said Elisabeth Kashner, director of ETF research at FactSet.

The wagers are also contributing to oil’s volatility because the U.S. Oil Fund normally holds futures contracts for oil to be delivered soon. After recent inflows, the ETF holds a large percentage of the total near-dated contracts. When that contract is close to expiring each month, the fund must “roll” it to the next month’s contract by selling the near-dated futures contract and buying the new one. This process prevents holders from being stuck holding actual barrels of oil. Typically, those contracts trade near each other, making the process relatively orderly.

With consumers unable to take advantage of low fuel prices, large gaps are emerging between prices for oil delivered soon and oil arriving months in the future. That forces the ETF to sell futures at the lower price and buy them for more, punishing investors.

Roughly $5 billion has flowed into the U.S. Oil Fund this year, with much coming in the past few weeks. It fell 15% to $3.18 on Tuesday. As of Friday, the fund held about 27% of the outstanding contracts for June U.S. crude futures. USCF said late last week it is shifting the fund’s structure to hold about 80% of assets in near-dated contracts and roughly 20% in second-month contracts.

On Tuesday, the company said it is shifting again so the ETF holds even fewer near-dated contracts

The U.S. Oil Fund finished rolling its May crude contracts to June during the week ended April 13, a process that traders said resulted in heavy selling and helped set the table for this week’s chaos. Even if the rolling process doesn’t immediately drive down crude prices, the large number of transactions involved can contribute to additional price swings.

Sharp-eyed traders anticipating the roll process can seek to profit by taking the other side of the trade. They can try to drive down the price of near-dated futures contracts or drive up the next month’s price.

Before futures contracts expire, they converge with prices in the physical market. Whoever is left holding contracts close to expiration must either sell them or take delivery of oil at the end of the corresponding month. The price of oil to be delivered in May tumbled to minus-$37.63 a barrel on Monday before expiring at $10.01 Tuesday, highlighting crumbling demand and forced selling.

“It’s enough to make a difference and threaten the integrity of the market,” Mr. Yawger said.

Mr. Douglas, the entrepreneur, said he was aware of the risks associated with owning the fund, but analysts say other investors probably weren’t. Some say investors were likely buying the oil fund to try to purchase cheap or negatively priced oil contracts for May delivery, not realizing that the ETF had already rolled most of its holdings to June contracts. They could soon face losses when the fund sells the June contract and buys July futures.

For the June and July contracts, the roll process is scheduled to occur between May 5 and May 8. Currently, July futures contracts cost about $7 more than June contracts, meaning the expense to roll contracts is again set to hurt investors. Analysts are speculating that the roll process will send oil prices even lower.

When oil to be delivered several months in the future costs more than the nearest-dated futures contract, analysts say the market is in “contango.” The gap is currently so large that analysts call it “supercontango.”

Traders say transactions in such a glutted market can be very risky. Singapore’s Hin Leong Trading Pte Ltd., a major participant in Asian energy markets, filed for bankruptcy protection last week. Some analysts speculated that Monday’s plunge below zero on the May futures contract could also have resulted from a struggling trading company being forced to sell to raise cash. Most investors already held June contracts. A flood of money into ETFs is also driving the chaotic price moves.

“This move is predominantly retail investors using poorly understood ETFs,” said Edward Marshall, commodities trader at Global Risk Management.

—Joe Wallace
and David Hodari
contributed to this article.