Experts divided on whether oil ETFs could exacerbate oil price swings

Oil Prices have plummeted to a six-year low in the past nine months. (Anthony/Flickr)

By Lucy Ren

Oil exchange-traded funds, a type of marketable security that mostly invest in oil derivatives, has gained immense popularity from recent rounds of oil price swings. However, market experts are still unsettled about whether the rising popularity of oil ETFs could have exacerbated the fluctuations in the price of oil.

U.S. Oil Fund, the world’s largest exchange-traded fund, was founded in April 2006. Like many other oil ETFs, USO invests in the West Texas Intermediate oil futures contract.

The WTI oil futures contract, which is the world’s most liquid forum for crude oil trading, collapsed to $43.46 a barrel in March from a peak of $107.26 last June. After a month of steady recovery, the price swung back to near $60 in May.

To Robert Martorana, a portfolio manager for Right Blend Investing LLC, an investment advisory firm he founded, oil ETFs are among the market innovations that have led to structural changes in the oil market.

“Once you turned oil into an ETF, it became more subject to sentiments and emotions,” Martorana said, “and what happened to oil prices is that the peaks went higher and the troughs went lower.”

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The long-only oil U.S. Oil Fund is designed to track the price of WTI crude oil by investing in oil futures contracts. The return on the fund has been negative since July. (Bloomberg, Lucy Ren/Medill)

As oil futures contracts near expiration, ETFs must roll the position over into the next maturity because neither ETF stockholders nor managers want to take delivery of the physical commodity.

This creates market activity called front-running, not to be confused with the illegal self-serving trading by unprincipled brokers, which bears the same name.

Floor traders, or the “front runners” of oil ETFs, knowing the schedules of the rollovers, may try to take advantage of the price differentials between the currently expiring contracts and the ones that expire farther out. They do so by buying ahead of the expected large orders from ETFs and then selling back to them at a premium when the monthly rollover takes place, reaping profits in the process.

Front running has been a fixture in the oil ETF world since its invention. While some experts think it aggravates movements in the price of oil under certain market conditions, others disagree.

“The accusation was that,”  John Gabriel of Chicago-based investment research firm Morningstar Inc. said, “the front running money in the futures market has exacerbated market contango,” a condition when the prices of oil futures contracts are increasing month by month, exceeding the expected spot prices of oil. But, he said, there’s no evidence to show the magnitude of the practice, much less its impact. “It’s totally anecdotal,” he declared.

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Prices of crude oil and the USO, the largest oil ETF, have declined by more than 55 percent from June to March. (Bloomberg, Lucy Ren/Medill)

Matt Hougan, president of the analytical website, calls oil ETFs “a drop in the bucket” of the oil market. He opined that they have no material impact on the massive market.

Hougan said front running has lost its significance over the years. “It did cause some degree of the fluctuation when the USO had a much more significant volume five years ago,” he said.

“If the entire complex was sold instantly, it would be less than 20 percent of one day’s futures market volume,” wrote Dave Nadig, chief investment officer of, in an email.

The current notional exposure of all WTI-based ETFs is $8.8 billion, Nadig declared, whereas WTI is usually trading over $50 billion in total value on a daily basis.

Judging from oil ETFs’ limited exposure to the oil market, Nadig said, it’s impossible for oil ETFs to have had any substantial impact on the price of oil.

Similarly, Ehud Ronn, a professor who specializes in energy industry finance at the University of Texas at Austin, opined that the major driver to contango is “low current demand and future expectation of higher oil prices,” he wrote in an email, “not the relatively-mechanical trading explanation.”

To Ronn, equity prices, which can better capture the spot prices of oil, are the factor reflecting and affecting movements in the oil market.

“I believe oil prices are driven by fundamentals of the oil market and the quite-proper interaction between oil and equity markets,” Ronn wrote in an email.

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By short selling oil derivatives, inverse oil ETFs perform opposite to the benchmarks that they are designed to track. (Morningstar, Lucy Ren/Medill)

But portfolio manager Martorana sticks to his guns.

The rollover cost of oil ETFs adds to market contango, he insists, because the portfolio managers “end up constantly buying high and selling low.” Although investing in oil futures may not be the perfect way to capture oil price movements, he said, it’s the best that ETF managers can do.

According to data tracked by Morningstar, oil ETFs have suffered losses in the range of 40 to 50 percent over 2014, whereas some inverse ETFs, which are constructed to profit from a decline in the value of an underlying benchmark in the oil market, have seen returns as high as 271.5 percent.

“ETFs are still in their infancy, there are going to be a lot of innovations in years” to come, said Phil Flynn, a senior market analyst at the Chicago-based Price Futures Group.

At the moment though, Flynn believes, oil ETFs actually have a stabilizing effect on oil prices, especially in today’s investing environment flooded with short-term participants like  high frequency traders. As a counterbalance to them, Flynn says, oil ETFs are ideal for investors and speculators willing to commit to their positions for a longer period, offering liquidity and long term stability to oil prices.

Like other market experts, Flynn stressed that, at the end of the day, oil prices still hinge on market fundamentals, or the factors affecting the supply and demand for oil. He owns a long-only oil ETF in his personal account.

“I think oil prices are more correlated with global central banks’ trying to stimulate the economy,” he said.

The quantitative easing after the financial crisis in 2008 has played the major role in turning the collapsing oil prices around, and the spillover effects include growth in other economies including China and India, Flynn said.

“We are in a state of oversupply currently,” he went on. “Although there are sharp cuts to production and capital expenditures, the rigs that remain online are the most productive rigs.”

Morningstar’s Gabriel said production would not be affected significantly until later this year or early 2016. His company expects oil prices to remain “under pressure for the foreseeable future.”

Photo at top: Oil Prices have plummeted to a six-year low in the past nine months. (Anthony/Flickr)