Can a negative oil price hurt passive investors?

20200427 – Can a negative oil price hurt passive investors.mp3

Dan Barnes Welcome to ETF TV, I’m Dan Barnes. Joining me today is Deborah Fuhr of ETFGI, to discuss the impact, that the negative price for the West Texas Intermediate Oil Future contract could potentially have on exchange traded products. Deborah, welcome back to ETF TV.

Deborah Fuhr Thank you.

Dan Barnes So just to start the discussion, can you explain the relationship between the pricing of commodities and the impact that potentially has on different types of exchange traded products?

Deborah Fuhr I think it’s important when you think about ETFs, you have to think about what is it trying to track or what is it investing in? So, is it investing in equities that are investing in oil companies or precious metal extractors or miners, or is it investing in different types of futures, or physical in some cases? So if you think of gold, it would be buying, in some cases, physical gold. So it’s very important to understand what you are actually investing in, or the product investing when you buy it. And then if you say it’s investing in WTI, what future contract is it buying? Is it buying the front month? Forward month? Is it buying some mixture of that? Because that will create different pricing and it will create different impacts on the assets in the product. Different providers of indices will be pricing off of different futures contracts, and products can have the ability to change the futures contracts that are buying, because they will have limits of how much they can own in terms of the outstanding of any futures contract. Often investors will say 10%. For some products, it can be higher, but they don’t want to own all of the outstanding interest in anything.

The other important consideration is if it is structured as a note, you have 100% counterparty exposure to that issuer, so a bank or whoever’s issuing it. The other thing to be careful about is understanding is it leveraged and inverse, or what is it trying to do and when does it roll futures contracts. So what you find is those products that were buying the May contract found that the price as it was getting ready to mature, was actually turning negative. And the reason for that is, it goes back to Russia and Saudi Arabia deciding to lower the price of oil. I believe that was due to the fact that they were trying to make it difficult for the shale companies in the US to continue to be competitive, because it’s more expensive to extract oil from shale than it is to get it from the oil wells that they have in Russia and OPEC countries. So I think that started some of the issue, and with the COVID-19, we’ve seen fewer people out driving, so the supply of oil and gas is much higher and there’s not a lot of places to put it.

What was happening; as the contract was coming close to maturing, we saw that the producers didn’t want to end up having that oil. And so what they were doing was basically, it was going to be more expensive for them to hold on to that oil and to close down their production, than it was to offer to pay people to take it off their hands. And that’s what ended up getting us into that negative oil price situation at the end of the contract expiring. So that impacts how ETFs are being priced, right, because if the futures contract they’re buying is moving into negative territory, what we saw was a lot of net new money going into certain products. And many people said, ‘well, how can the number of shares outstanding go up? But yet the assets have gone down?’ Well, that’s because the value of what it’s investing has gone down. It’s basically tracking what it’s supposed to, and it’s doing what it’s supposed to. But clearly, we’re in a very unique situation where we’ve never seen this happen before. But I do think that we’ve seen the June contract now also come down in price. So at the time of the expiry of May, the June contract was much higher. They were calling it ‘super contango’, but we are seeing the price come down slightly.

Dan Barnes Let’s just explain that term: contango.

Deborah Fuhr So, contango means that what you’re buying today is less expensive than buying something in the future, which is unusual because typically buying something today, you pay more. If you pay for it in the future, it’s usually less expensive. And that differential is so much that people are calling it now super contango as opposed to just contango.

Dan Barnes Yes, absolutely. Now, the Chicago Mercantile Exchange has come out and said that their WTI futures contract is not available for retail investors. They’ve been slightly defensive about the situation, one might say. Of course, the thing about exchange traded products is they are often available for investment by retail investors. So what are the potential exposures that retail investors might have found with this issue?

Deborah Fuhr For most people, when they’re buying ETFs, they’re buying plain vanilla, market cap equity or some fixed income exposure, so when you think of the 5.37 trillion dollars invested in ETFs, 71% of the assets are in equity products, 21% are in fixed income, so commodity products are only 3.5%. And clearly, if most people were to think about, how am I saving for retirement, your money would typically be in either a conservative dynamic or more aggressive combination of typically equities, fixed income, maybe commodities and maybe something else. So when people start venturing into oil or cotton or corn or other investment, then that’s more of a trading investment. Unless you’re highly sophisticated, you really need to think about what are you saving for, and what is your time horizon? And if you don’t understand something, everyone should be reading the prospectus. The problem is most people don’t. But you have to think about, why are you buying this thing?

I think one of the challenges is, as we all sit at home and watch a bit more TV than we ever have before, it is interesting how if you watch the news shows, now, instead of talking about indices, they’re talking about different ETFs. And so I think for many people who are sitting there not knowing what to do with their day, watching the TV and thinking, ‘oh, this is going up or this is going down,’ they see tickers and they think, ‘oh, I’ll just buy some of that and they don’t go away and do their homework.’ So I would say people have to understand what it is they’re buying, what’s inside of it, and it does go back to what we discussed last time, which was the impact of index providers not doing rebalances. You could find that you invest in something through a product, that actually wasn’t in the universe that you expected, because they didn’t rebalance and some of the companies might have become high yield debt as opposed to corporate grade debt when they initially were put into the index. So I think understanding what you invest in, both the prospectus, and uniquely ETFs are transparent, so you can go see what’s inside of them.

Dan Barnes What are the risks in terms of losses for investors and ETPs that do track this contract?

Deborah Fuhr So what you’ll see is, because the value of the contract is going down, the value of the ETF is going down. There are also in many products criteria that will say, if the price drops by more than a certain amount or assets dropped by more than a certain amount, the insurer may decide to redeem them. So we have seen that happen with a product in the US. I don’t really want to go into specific products, because the intention is more broadly to get people to look at and understand the products. So I think people need to look at, what are the different thresholds that would cause ETFs to change what they’re investing in? Or to potentially be forced to redeem. So basically, they closed their quarterly redemption, but we are seeing that happen.

Dan Barnes Excellent, Deborah, thanks very much.

Deborah Fuhr Thank you.

Dan Barnes I’d like to thank Deborah Fuhr for her expertize, and of course you for watching. To catch up on our other shows, go to ETFTV.NET or TRADERTV.NET.

Published on April 27, 2020