CAN THE USO FUND COLLAPSE? / THE FINANCIAL TIMES

Can the USO fund collapse?

By: Izabella Kaminska


© Bloomberg


This is a quick follow-up post on the USO piece out earlier as the fund has just announced it will be suspending new creations because it has run out of preregistered shares to provide to authorised participants.

Please excuse typos, et cetera (we are out of babysitting time and encumbered by a two-year old).

So what does it all mean?
ETFs (or rather ETPs, because the USO is actually an exchange traded commodity product) have to preregister shares in bulk to avoid having to go through a regulatory process every time a share is offered to the market.

They effectively retain this preregistered stash which they provide to APs whenever they deliver underlying basket constituents to them for creations.

This is not dissimilar to how some cryptocurrency ICOs retain coins with a view to selling them into the market over time.

The USO has now run out of registered shares to offer to APs and is thus suspending creations, but not redemptions which can still go ahead. Until its request for the registration of 4bn of new shares is approved, this will probably remain the case.

As the USO stated in its filings in anticipation of such a scenario:


In the event that there was a suspension in the ability of Authorised Purchasers to purchase additional Creation Baskets, management believes that Authorised Purchasers and other groups that make a market in shares of USO would still continue to actively trade the shares. However, management believes that in such a situation, Authorised Purchasers and other market makers may seek to adjust the market they make in the shares.

Specifically, these market participants may increase the spread between the prices that they quote for offers to buy and sell shares to allow them to adjust to the potential uncertainty as to when they might be able to purchase additional Creation Baskets of shares. In addition, Authorised Purchasers may be less willing to offer to quote offers to buy or sell shares in large numbers.

The potential impact of either wider spreads between bid and offer prices, or reduced number of shares on which quotes may be available, could increase the trading costs to investors in USO compared to the quotes and the number of shares on which bids and offers are made if the Authorised Purchasers were to still be able to freely create new baskets of shares.

In addition, there could be a significant variation between the market price at which shares are traded and the shares’ net asset value, which is also the price shares can be redeemed with USO by Authorised Purchasers in Redemption Baskets.

The foregoing could also create significant deviations from USO's investment objective, i.e., for the daily changes in percentage terms of its shares’ per share net asset value (“NAV”) to reflect the daily changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in the price of a specified short-term futures contract on light, sweet crude oil called the “Benchmark Oil Futures Contract,” plus interest earned on USO’s collateral holdings, less USO’s expenses.

Management believes that any potential impact to the market in shares of USO that could occur from the Authorised Purchasers’ inability to issue new Creation Baskets would not extend beyond the time when additional shares would be registered and available for distribution.

So what we can expect — in the event inflows remain constant — are greater tracking deviations for the fund, wider spreads, and a growing disconnect between the price of the ETF and its underlying net asset value. The ETF will probably trade at a premium.

This will also have an impact on the ETF’s influence on the underlying WTI market in which it is already overly dominant. Any buying support the fund had been offering to Front-month futures thus far will in effect be removed. This could lead to yet more weakness for oil prices.

Two quick specific follow-ups to our screencast we published this morning about the USO based on informed feedback (which, of course, we greatly value).

We showed a chart in which compared the USO’s shares outstanding to assets under management, and noted it was interesting that the former was growing more quickly than the latter. It’s fair to say, this is mainly due to the falling share price which will be impacting the value of legacy assets in relative terms. So no mystery there after all.

On the create-to-lend function which we discussed, we want to add that, in theory, the mechanism has the capacity to increase short interest in the fund without necessarily adding to shares outstanding. This is because of the way flows are internalised and offset by APs/PBs.

Back in 2010, Andrew Bogan et al explained how this sort of (effective naked) short selling creates a type of rehypothecation effect where the very same shares appear to be owned by many multiples of owners.

As he noted back then:


While an ETF owner believes their ETF shares represent ownership of the underlying shares of stock in the index that the ETF tracks, that stock is not always all there. Because of explosive short interest in some ETFs, owners of ETF shares often far outnumber the actual ownership of the underlying index equities by the ETF operator. One might ask how that can be possible, but the creation and redemption mechanisms inherent to ETFs mean that short sellers need not be concerned about the availability of shares outstanding when they sell an ETF short—since they can always create new shares using creation units to cover short positions in ETFs in the future. In essence, there appears to be no risk to being naked short an ETF since the short seller can always “create to cover”. This has led to some ETFs having shockingly large short interest as compared to their number of shares outstanding and for every additional ETF share sold short, there is another owner of that share.


As stressed above, the industry never viewed this as a risk because in theory there is no limit to creations if and when a short-covering run emerges in the market.

It is not at all clear that this is behind the recent growth of the USO, and indeed, better secondary market liquidity in the US means shares can often be located for shorting easily without the need for a create-to-lend mechanism. But in theory, anyone taking an exceptionally large short position or wanting a bit of discretion (remember the Paulson CDO short?) might still be inclined to engage in a create-to-lend contract specifically.

For more on how naked short-selling may lead to under appreciated operational risk in ETPs and ETFs do see this paper from 2016.

As it concluded:

Thus, the unique structure of ETFs and the AP’s ability to sell shares on an intraday basis that have not been created (or at least the underlying basket of securities has not been delivered) can lead to improvements to trading in individual ETFs but, at an aggregate level, it can create greater counterparty risk that has potentially destabilising effects in the broader market for not only ETFs but also the underlying securities held by these ETFs.


FYI we’ve reached out to USO APs and the USO fund managers to gain more clarity on what they think is driving the growth but are yet to speak to either.

No doubt buying interest from retail investors is a big part of the USO destabilisation story. But it’s possibly not all of it.