A crude-oil storage facility in Cushing, Okla.; Oklahoma suffered a severe shortage of storage tanks in April.
Photo: johannes eisele/Agence France-Presse/Getty ImagesNot so long ago, a lot of sophisticated funds were convinced about an investment that promised something for nothing. Owning commodities was supposed to give them diversification from stocks and bonds, steady returns and an occasional windfall.
The strategy was a disaster, but Mom and Pop never got the memo and have kept plowing money into one of the worst commodity investments on the market, the now-infamous United States Oil Fund. Since its inception over 14 years ago, the fund has lost 95% of its value.
You can’t just blame oil prices. Unlike with some precious metals, which asset managers can store in a vault, funds tracking industrial commodities have to own futures contracts. For more than a decade, the shape of the oil-futures curve has created a drag on USO’s returns. It often rolled expiring contracts into more expensive ones—the opposite of the steady return sophisticated funds coveted. Over the past 10 years, the fund has lost twice as much as the spot price of West Texas Intermediate oil, which it aims to track.
That slow burn threatened to become a bonfire in April. The fund held an alarmingly large position in June WTI futures contracts when the May contract turned negative due to a severe shortage of storage tanks in Oklahoma. Perversely, that oil-price drop prompted many poorly informed bargain hunters to buy funds like USO, increasing the fund’s destabilizing position and drawing the ire of regulators and its main exchange. Since fund owners could only lose 100%, a similar plunge in the June contract could have left counterparties high and dry on futures contracts with a negative value.
USO quickly changed its structure to avoid disaster. Nevertheless, the fund was authorized by the U.S. Securities and Exchange Commission last month to issue up to a billion new shares. Buyers wouldn’t be getting the same thing, but is it a good thing?
There are a handful of reasons why even another oil-price drop shouldn’t tempt bargain hunters. Ilia Bouchouev, former head of energy derivatives for Koch Industries, thinks that going forward the shape of the oil-futures curve will veer frequently between contango—the money-losing shape for a fund like the USO—and its opposite, backwardation. That coming shift could alleviate the drag for USO.
Contango occurs when the price of oil further out in the future is more expensive than the nearer-term futures. A fund like USO often loses money in a structure like this because, as the futures contracts it owns near maturity, it must settle them and buy more expensive ones expiring later. The presence of so many financial speculators over the past 15 years is thought to be one reason for contango. Mr. Bouchouev thinks the fading popularity of commodities speculation could spur backwardation but that it would quickly revert once traders see opportunity for positive carry.
The main reason to exercise caution, though, is USO’s identity problem. As if it wasn’t already straying far from the actual WTI spot-price performance, the fund—following the April collapse in futures—has been forced to adopt a formula that diverges even more from its objective.
There are now nine steps involved in deploying USO’s holdings in a waterfall structure. If the fund can’t buy enough near-term WTI futures, it will go to the next month’s contract, all the way to the 12th month. If that doesn’t suffice, it will buy Brent oil futures. Then it veers off to even more distant territory that involves refined products, including ultralow sulfur diesel and gasoline, and so on. The bigger the fund gets, the more it is likely to deviate from its original mandate.
All of this leads to a very unclear vision for the fund. While making a disastrous “less than zero” situation unlikely, it could be an even worse drag on returns. Investors looking to passively get exposure to oil prices might do better to invest in broad-based energy-stock funds. The Energy Select Sector SPDR Fund, for example, lost 32% of its value in the past decade, a performance that is better than WTI crude’s 45% and USO’s 89%.
Boilerplate legal language routinely warns investors that past performance may not be indicative of future results. Sometimes it is a pretty good hint, though.
Write to Jinjoo Lee at jinjoo.lee@wsj.com
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Don’t Buy an Oil Fund With an Identity Problem - The Wall Street Journal
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