The United States Oil Fund (USO 1.00%) is a popular way for retail investors to attempt to trade in oil prices. On the surface, it might seem like a smart move: Buy USO, a fund that's designed to track the daily movement of West Texas Intermediate oil prices, and make money when oil prices rebound, right?
The obvious answer would seem to be "Yes, you should buy USO." After all, USO is still down 83%, making it a far better way to profit from a resurgence in oil prices than oil stocks like ExxonMobil or Phillips 66, down about one-third at recent prices.
USO isn't a simple investment in the price of oil. Image source: Getty Images.
The problem with that calculus is that it ignores how USO works and why USO is actually a far more dangerous investment than you might realize.
How USO works
USO is marketed as an exchange-traded instrument -- meaning it trades on a stock exchange -- designed to track the daily price of West Texas Intermediate crude oil. Sounds pretty simple, right? But what's not simple is how USO's traders attempt to track WTI crude prices.
USO buys and sells oil futures to track WTI prices. These future contracts are derivative instruments that actually require the holder of the contract to take physical delivery of crude oil at expiry. Obviously USO isn't in the business of taking physical delivery of oil, so it sells out of contracts before they come due each month, rolling the proceeds into contracts set for a future delivery date.
In a more normal market, this works fine. However, what we are experiencing right now is anything but normal, with record levels of demand destruction and a massive oversupply as producers have been slow to cut output. U.S. production has started to fall, but Saudi Arabia and Russia, the world's third- and second-largest oil producers, have reportedly increased their oil output in April.
Continental US Crude Oil Field Production data by YCharts.
To put it plainly, right now, there should be reduced futures activity for West Texas crude. There's less demand, and producers are starting to cut production. But in the ironic way that investing works sometimes, the sharp increase in interest from retail investors has led to a massive influx in new investor capital that the fund has had to use to invest in new futures contracts.
This played a role in a historic event on April 20, when U.S. oil prices went negative. USO, along with other trading firms that have no intention -- or even any capacity -- to take possession of crude oil, were holding a substantial number of contracts for May delivery of crude only a day before those contracts were set to kick in. Thousands of those contracts were sold at negative prices, meaning sellers like USO were literally paying the contract buyers to take possession of the oil.
At the bottom, May deliveries of WTI crude oil were going for negative $38 per barrel, meaning buyers with the capacity to actually take delivery of that oil were getting paid $38 per barrel, and they'll get the oil to sell at a later date. In a normal market environment, the difference between this month's and next month's futures shouldn't be so dislocated, and for USO, this sort of contango environment makes it almost impossible to track oil prices.
It gets worse
The sad irony is the increased interest in oil prices, and individual investors flooding capital into USO has actually made it nearly impossible for the fund to track oil prices. The fund has made changes to its strategy to adjust to this influx of capital and to reduce the risk of another negative-trading event. But there are significant risks that it will be increasingly difficult for USO to avoid being left holding contracts it cannot find a buyer for in the weeks and months ahead.
The fund's managers are doing everything they can to stay ahead of this possibility, including recently conducting a 1-for-8 reverse share split that moved the price of USO shares higher. Not only did this move "reset" the per-share price closer to that of the WTI crude benchmark, but it also likely made it less attractive to investors looking at a single-digit price and mistaking it for a value investment.
Yet even with the actions management has taken and will likely continue to take to limit its exposure to being left holding the bag again, the stark reality is, the crash in demand and continued oversupply of oil is likely to continue to drive WTI futures prices down sharply heading into expiry each month.
USO's management simply might not be able to keep the fund liquid if it keeps getting forced to offload futures contracts for such a massive loss as we saw on April 20.
The risk of a total wipeout
It's not very often an investing fund's biggest "problem" is investor interest, and that, along with the collapse in demand for oil in the U.S., is why USO is at risk. The fund has seen substantial capital inflows at a time when oil demand is falling to Vietnam War-era levels, painting USO into a corner from which it must buy futures to meet the demand from new investors, even when the demand for the crude those futures promise delivery of won't be there.
And that puts USO in a terrible position. Even drastic measures to push some of its investments into 2021 futures might not be enough to offset the risks of another April 20 happening in the months ahead that the fund cannot survive. A worst-case scenario could include USO being forced to liquidate all of its futures holdings to meet its financial obligations. If that were to happen, USO shareholders would be completely wiped out, even if oil prices look like they're starting to improve.
