Negative Oil Prices – What is happening with the USO ETF? | How do ETF’s work?

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Hello youtube welcome back to patrick boyle on finance so i put up a video yesterday on the topic of what does it mean the crude oil has a negative price and it turned out to be the the by far the biggest video i’ve ever put up on youtube and i received a ton of questions in the comment section so i thought i’d try and answer some of those questions today in a

New video and so the big questions were coming in we’re all about etfs because that’s how an awful lot of people invest in things like oil you know they don’t buy physical oil as i explained yesterday they often don’t trade oil futures what they do is they invest in an etf like uso and the idea of that is that it gives an investor exposure to to crude oil prices

In particular the the uso it stands for us oil fund and attracts west texas intermediate crude and in particular the front month so what is an etf further and etp yesterday musingly in my biggest video ever i erroneously said they’d stood for electronically traded fund rather than exchange-traded fund and so i got a lot of comments about that but um but anyhow an

Exchange-traded fund is simply it’s kind of like a mutual fund in that it will hold a basket of securities and he often will say for example they’ll hold stocks right so you’ll have a fund that’s made up of a bunch of stocks usually an index and you you can buy and sell the fund through your broker like a single stock so it basically provides the diversification

Benefits of a mutual fund with the ease of buying and selling that you get trading stocks you can just buy it and sell it throughout the day and actually they also can be shorted and so a lot of hedge funds use etfs in order to to short not not necessarily that they’re always short but it’s often an easy way of hedging other positions so if they’re long a bunch

Of oil stocks and they want to hedge their exposure to the oil market they could short usl for example so the fund basically owns whatever the underlying is usually it stocks in the case of us oh it’ll be futures contracts on oil and then they put together a fund structure that will track the performance of the underlying assets and they sell shares in that fund

To investors what’s going on with us oh well the us oil fund fell more than 20% this morning before being halted pending news and at the time of making this video it’s trading at around 2 dollars and 40 cents a share which means that it’s almost half tin a week so you know well this big moves in oil and this big moves in u.s. oh now a lot of people asked me is the

Reason for the super contango that we talked about yesterday does that relate to us oh rolling and i don’t believe that would be true simply because us oh in in their mandate they actually roll to two weeks before the futures contracts expire so they should have rolled well in advance of of what’s going on but basically one of the things that’s happening with the

Uso is that there’s been a huge increase in the open interest and that basically means there’s a lot of investors out there possibly retail investors who’ve just seen oil prices fall an awful lot and they want to bet uh noil prices going back up now i explained yesterday that the problem with making a bet like that using futures is quite simply that futures have

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These expiration dates right so the futures contract that expires at the close our trading today in fact by the time i get this video uploaded it’ll probably have expired but that contract is trading at a big discount to the june contract which will probably by the time you’re watching this actually be the front month contract but what happens is that when markets

Are in contango like they are right now you keep sort of having to sell the the cheap contract and the expensive contract and as i explained yesterday it’s a little bit like paying someone to store oil for another month for you and at the moment because there’s not much storage capacity it’s very expensive to pay someone to store your oil for you so the u.s. oil

Fund actually holds between 25 and 30 percent of the open interest in the june contract for west texas intermediate crude oil they saw about 1.5 billion dollars in inflows as retail investors tried to pick the turning point for oil prices so essentially there’s a lot of people who do want to bet on oil prices going up simply because oil prices are quite low and

They think well you know maybe they’re low because there’s coronavirus thing but i can buy oil and eventually the price will go up but the problem is of course that they get hammered by this role of the futures where you keep on having to roll out of the low-priced future into the high priced future and then that happens over and over again now that’s just when a

Market is in contango when it’s in backwardation you actually get what we call a role yield from rolling the futures but anyhow a few things have happened within this etf so there’s been this huge inflow of money which is actually problematic for them and they actually changed the structure of the fund on friday that they applied for regulatory approval to change

The structure of the fund so that they can hold longer dated contracts that are no longer a hundred percent in the front month and so right now eighty percent of the fund can be in the front month contract with twenty percent in the second month contract so they’re sort of easing i guess their impact on on the role of futures this matters a lot actually just because

The etf is huge like it’s a very large percentage of what’s going on in people buying and selling oil surprisingly enough and so etf have to pre-register share this is what’s going on this was what was announced when they when they closed the the market this morning for an announcement so an etf actually has to pre-register shares in bulk with market regulators

In order to avoid having to go through a registration process every time new shares are issued so what they usually do is when they launch the fund they’ll pre-register an awful lot of shares way more than they think they’ll need and and then they’re able to issue them or redeem them as necessary throughout the life of the etf but because so many new people have

Come into the oil marketer started buying the us oil etf what’s happened is that they’ve run out of pre registered shares and so they’ve applied for approval to i think create four billion new shares but they of course have to wait for regulatory approval on that so we’re in a funny situation where there’s a lot of people who maybe want to buy these shares but

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The the etf provider is not able to create new shares until it’s approved by the regulator so atm has exploded but new shares can’t be created so i probably at this point it explain kind of how ets works so in an etf structure you have the etf sponsor who which is the the person who came up with the idea of the etf they market the etf and so on and then you have

What are known as authorized participants which are a little bit like market makers or something like that and the the authorized participants are usually investment banks sometimes brokerage firms who are allowed to deal with the etf sponsor so the authorized participants which are referred to usually as aps are able to either present a basket of securities and

Create etf shares or do the opposite where they can just take a basket of securities and redeem etf shares so they are able to create or redeem eta shares by trading in the underlying security and so for example if you imagine if there’s an awful lot of demand for the etf and the the etf price starts to go up more than the the price of the underlying like crude

Oil what they would do is they would issue shares in the etf and then they would deliver futures in order to sort of cover that position and so and they would make a profit off of the difference in price between the etf and the price of the futures that were required to make up those shares so our authorized participants can buy shares and submit them in exchange

For derivatives or they can sell shares and submit derivatives in exchange for them in in the case of the the uso etf now what would happen there’s i think there’s probably about 18 different aps within the structure of the uso etf so there’s a bunch of them if no ap step in then what happens the rules are that the the etf trades like a closed-end mutual fund and

It can basically at that point start trading at either a discount or a premium to the nav the net asset value of the oil or whatever is supposed to be inside that etf until an ap steps in and becomes active trading the the fund and the underlying and so essentially you know an arbitrage could open up for these aps but they’re in a sort of a sticky situation right

Now where no new shares can be created so uso right now is not authorized to offer new shares to aps so shares can be redeemed so if people were selling an awful lot your the aps are able to redeem them but no new ones can be created so if the inflows remain constant if retail investors keep on buying this etf even though no new shares can be created what can happen

Is that we can see a disconnect in the price between the etf and it’s underlined net asset value and basically you would see the uso etf trading at a higher price than the price of oil or at least in the oil contracts that that should be making up the etf and so if in the current market environment where we’re seeing a huge influx of money coming in to actually

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Buy this etf i know it sounds surprising you see the oil price down but there’s lots of people investing but actually you see that a lot with ets because there are a lot of investors who like to go counter cyclical they basically look at it and they say well it’s down so much it can only go up from here and so that might be you know the idea amongst a lot of these

Investors the etf like the uso etf is essentially overly dominant as it is in its influence on the wti market and this this sort of lack of new shares being available has the impact of reducing the buying pressure on front month wti futures because if no new shares have been created then the aps aren’t actually going out and buying the front month futures right so

The price of the etf can go up and the futures don’t get any real buying pressure on them and equally it decreases the selling pressure on the uso etf because normally the the aps would be selling the etf and buying the futures they can’t do that right now so that’s really the situation right now with with us o that’s what’s going on in the market i guess wanted

The takeaways like i i don’t really want the takeaway of this of my videos just to be sort of a cnbc type thing where i just tell you what’s happening in the markets because you can you can google that yourselves what’s useful about this information we’re really the thing the thing i find interesting here is essentially how do ets work on what do you get when you

Invest in these things because an awful lot of the time like maybe with some simpler etf’s you really they’re they’re easily understood and you get what you think you’re getting while a lot of people who are probably buying the you so etf don’t really understand that there’s futures underlying it they don’t understand the nature of rolling these futures that the

Nature of things like contango or backwardation in you know commodities markets or in derivatives markets and so in a funny way you know anyone can trade this thing but it’s worth if you are an investor if you’re putting your you know money at work trying to build up a retirement account it’s worth really kind of reading into an understanding these things before

Investing in them because often they look really simple and you’ll read kind of a one-line description of it you’ll sound like well that’s great i can bet on oil going up and this doesn’t expire like futures do as i explained in yesterday’s video but even though the etf doesn’t expire the things that invests in do expire so you end up getting that at least in this

Current market environment that negative role yield on futures so that’s it for today’s video do hit the like and subscribe buttons if you’re interested in this kind of finance and derivatives type stuff take a look at the link in the description below where i have a book on financial derivatives that i linked to there’s also a book on corporate finance that’s on

Amazon and i have a new one coming out soon on statistics anyhow talk to you guys later bye

Transcribed from video
Negative Oil Prices – What is happening with the USO ETF? | How do ETF's work? By Patrick Boyle

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