As I watch all the craziness that is going on with the United States Oil Fund LP (USO), I can’t help but feel a sense of deja vu. Everything that is going on with the fund, from the billions of dollars of inflows to the suspension of creations to the huge premiums that have now developed, happened to a similar product in 2009.
That product is the United States Natural Gas Fund LP (UNG), an ETF with the same issuer as USO—US Commodity Funds. Today a relatively niche product with modest assets of $413 million, back in 2009, it was the hottest ETF in the commodity markets.
Specious Opportunity In Oil
As anyone who has been keeping up with the oil ETF space is well aware, USO has been a disaster for anyone who has bought into it. (Read: More Big Changes For Biggest Oil ETF)
My inbox has been inundated with emails from retail investors disappointed in the performance of USO, which has lost 80% of its value just this year.
Made aware of the oil crash from wide mainstream press coverage, investors who ordinarily wouldn’t be involved in the commodity markets have dived headfirst into the risky ETF.
Since the start of the year, $5.9 billion has flowed into USO, with $3.2 billion of that coming in just the last nine trading sessions. This is for a fund that, at the start of the year, had only $1.2 billion in total assets.
To those unfamiliar with commodity markets or commodity ETFs, the oil crash seems like a highly attractive opportunity. On the surface, it looks straightforward: If you can buy oil at these record low prices, you can sell it a few months or a year from now for a tidy profit. After all, the world will still need plenty of oil in the future.
Unfortunately, due to the structure of futures markets and the lack of storage capacity in the physical markets, that trade isn’t so straightforward. Rapidly filling inventories have sent crude oil prices plunging to unbelievably low prices, and the same phenomenon has created a super contango in the futures curve, steeply increasing the cost of rolling futures contracts.
Investors who bought USO just a week ago when oil was $20 (at the time, an 18-year low) are already down 43%. And because the fund has to sell cheaper near-month contracts for much more expensive later-month contracts to carry its futures position forward, it becomes increasingly more difficult for the fund to make up its losses as time goes by.
Quickly, the oil opportunity has turned into an oil nightmare. Yet either from existing traders doubling down or new traders unaware of the ETF’s pitfalls, money keeps pouring into the fund. That’s kept USO’s assets close to $4 billion, even including the billions that have been wiped out (if there were no losses in the fund this year, and inflows were the same, assets would be closer to $7 billion).
The fund has gotten so large that the issuer has had to shift strategies from one that holds front-month futures to one that holds multiple contract months in order to avoid running afoul of Commodity Futures Trading Commission position limits.
USO also had to temporarily suspend creations—one half of the mechanism that keeps an ETF’s price close to the value of its underlying holdings—as the number of shares the fund can issue ran out.
In turn, USO’s share price exceeded its net asset value (NAV) by a whopping 36.5% on Tuesday. That premium shrunk to 8.7% on Wednesday, but USO would be down much more than it already is if the mechanics of the ETF were working properly.
USO Premium Skyrockets
The Story Of Natural Gas
That brings us back to the aforementioned natural gas ETF UNG. This is an ETF that also caught the attention of bargain hunters—mostly retail traders who saw the plunge in natural gas prices during the financial crisis as an opportunity to make a quick buck.
Prices for the heating and power generating fuel fell from a high of nearly $13.50/mmbtu in July 2008 to a low of $2.50 in September 2009. Starting in about April 2009, when prices first crashed through $4, inflows into UNG began to explode. From April 1 through July 7, $4.1 billion was added to the fund. For context, the ETF only had $795 million in total assets under management on March 31 of that year.
UNG Assets Under Management
At the peak of the buying flurry, hundreds of millions of dollars were being added to UNG each day, but then the inflows abruptly stopped—not because there wasn’t demand, but because US Commodity Funds had run out of shares to issue. Sound familiar?
Like USO, UNG is a commodity pool, and so it must register with the SEC when it wants a new subscription of shares. That's in contrast to most ETFs, which are registered as investment companies under the '40 Act, and don’t require registration of additional shares as the fund grows.
Within days of the suspension, UNG’s premium rocketed higher. On Aug. 28, 2009, it hit a peak of 19%—not quite the level of USO’s highest premium, but substantial nonetheless. That tells you how much underlying demand there was to catch the falling knife in natural gas prices.
The fundamental backdrop for natural gas back then also shares similarities with that of oil today. Demand had fallen off a cliff due to the Great Recession and supply was surging due to the fracking revolution. Then, too, the prospect of “full storage” was front and center on traders’ minds, with some (myself included) raising the prospect of prices falling close to zero.
Prices never did fall to zero, but they dropped precipitously, eventually hitting $2.50 in September, a seven-year low at the time.
Broken For Awhile
On Aug. 12, 2009, more than two months after filing to register more shares with the SEC, UNG was granted its request.
But the ETF didn’t immediately restart the creation mechanism. The fund issuer said that position limits and restrictions on energy-based commodity futures contracts set by CFTC and the exchanges were hindering it from operating as normal.
The fund had gotten so large that it was holding more than 100,000 contracts, equal to 70% of the open interest on front-month natural gas futures.
That’s not too dissimilar from what happened to USO a week ago. The fund had exceeded the 25% position limit set by the CFTC earlier this year, forcing the fund to pivot from just front-month contracts into a mix of front-month and later-dated contracts.
On Sept. 28, 2009, 12 weeks after suspending creations, UNG finally resumed them on a limited basis.
To get around the limits on its futures positions, the fund would accept over-the-counter swaps on natural gas from authorized participants in exchange for creation baskets. That exposed the fund to a bit more credit risk, but generally did the trick in getting the fund’s price back in line with its NAV.
UNG Premium To NAV
All The Downside, Without The Upside
By the end of September, things were also looking up for natural gas prices. From a low of $2.50 on Sept. 3, they rebounded to $4.88 by Sept. 29, on their way to $5.57 by the end of the year. If things ended there, we might be talking about a happy ending.
Unfortunately, the steep decline in prices through early September, along with a super contango in the futures curve, had exposed UNG buyers to all of the downside and very little of the upside. So, while natural gas increased from $3.78 to $5.57 from April through December (the period in which inflows were going gangbusters), UNG was actually down 34% in the period.
UNG (Blue) vs. Futures (Yellow)
Even those who purchased UNG on Sept. 3, 2009, at the very bottom of the market, only gained 11.9% through year end due to the contango and the premium to NAV that they purchased at.
The story gets even worse longer term. December 2009 was actually a high point for UNG. The fund never regained those levels and continued to drift lower and lower over the next few years. Even a temporary low wasn’t made until April 2012.
Today UNG sits at a fraction of the price it was even at its trough in 2009—down 95% from that level and with only 7% of the assets it commanded at its peak.
The parallels between UNG 11 years ago and USO today are uncanny.
From the issuer to the buyers to the structure of their underlying markets, there is so much similarity between what is going on with the oil ETF USO today and what happened to the natural gas ETF UNG more than a decade ago.
Of course, what happens with USO doesn’t have to play out exactly like it did with UNG. Theoretically, it is possible that recent buyers of USO could come out ahead when all is said and done.
But between the premium, the contango and the weak near-term fundamentals, it will be extremely difficult to achieve that.
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