Stock market investors have seen huge swings in share prices across just about every sector of the economy as businesses come to grips with the realities of the coronavirus pandemic. The energy markets have seen some of the biggest disruptions of all, with crude oil prices plunging on fears of reduced demand during a prolonged period of lower economic activity. In anticipation of better times ahead, many energy-market participants believe that what's gone down has to come up.
United States Oil Fund (USO 3.60%) has gotten a lot of attention lately as a potential way to get exposure to crude oil prices. However, the fund has had to make major changes to its investment strategy in response to the volatile price environment.
That's not because the fund has suddenly turned bearish on oil. Rather, it's a much simpler calculation: U.S. Oil Fund wants to survive, and it would rather be less effective in meeting its purported investment objective than disappear entirely.
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The big shift away from spot oil
U.S. Oil Fund was designed to track the West Texas intermediate crude market, with the goal of matching daily changes in the spot price of oil. To do that, the fund invests in futures contracts so that it doesn't have to deal with physical crude oil.
Historically, the futures contracts that USO concentrated on were those expiring within the next month or so. Those contracts best reflected spot prices, and within a pre-determined period each month, the fund would sell off contracts about to expire and replace them with new contracts from the following month.
However, U.S. Oil Fund recently changed that strategy. In a series of moves, USO has completely abandoned the recognized near-month futures contract, instead, spreading out its exposure to contracts with as much as a year left before expiration.
A matter of survival
It's tempting to conclude from the shift that USO has gotten bearish on near-term crude oil prices. But the reason is much simpler: USO wants to survive. Specifically, it doesn't want to put itself in a position from which it can't recover.
U.S. Oil Fund actually dodged a bullet when prices of near-month futures contracts went negative in recent weeks. The fund had already done its monthly move to the following month's contracts. Had it not already done so, USO would've faced liabilities that could have shut it down entirely.
If that sounds overly dramatic, it shouldn't, because it's happened before with other types of funds. In early 2018, the VelocityShares Daily Inverse VIX Short-Term ETN found itself taking huge losses when the CBOE Volatility Index soared in a huge one-day move. The losses were so large that the fund closed operations within two weeks.
The similar ProShares Short VIX Short-Term Futures ETF (SVXY +0.80%) stayed open, but it changed its investment strategy to reduce its exposure. In particular, the ProShares fund had previously sought daily changes equal to the inverse of the move in the CBOE Volatility Index, but after the shift, it targeted changes only half as large as the inverse. The fund has seen smaller gains during times of low volatility, but it's also seen smaller losses when market turbulence rises.
USO is making a similar calculation. It has a goal of tracking spot oil, but if in doing so it's exposed to a catastrophic loss that would force it to close, it'll sacrifice that goal to stay in business.
Is U.S. Oil Fund still a viable investment?
At this point, investors can't count on U.S. Oil Fund as a tracker of spot oil prices. That doesn't make it a terrible investment. Even futures contracts with expirations a year from now still reflect some of the supply and demand considerations of the crude oil market. In some ways, that longer-term perspective is actually a better way to bet on the fundamental strength of oil markets.
Nevertheless, what most people who are interested in USO right now seem to want is that spot oil exposure. The shifts the fund has made are setting those shareholders up for disappointment if a future oil-price recovery doesn't get reflected in the particular crude oil contracts USO owns at that moment. That's not ideal for oil investors, but it's a price that U.S. Oil Fund is willing to pay to ensure its own future survival.
