Most thought the ETF invested in spot oil, while it bought oil futures and rolled them over.

And therein lies the difference, or for a lot of chagrined retail oil investors, a hole in their pockets. The United States Oil Fund (NYSEARCA: USO) took positions in front-month oil futures and rolled them over every month. It did not, as retail investors mostly assumed, invest in the spot oil market. (CNBC)

The oil market in contango

Futures in the oil market generally trade on “contango,” a phenomenon whereby contracts with later expiries are priced higher than current ones. The difference represents the costs of storage and financing.

However, the coronavirus triggered global lockdowns that destroyed oil demand in the foreseeable short term. As a result, prices of front-month oil futures plunged. The usual contango situation has now turned into a “super contango.”

For USO, its front-month holdings have similarly fallen in value and the fund will have to pay an enormous spread to roll over its futures positions. Investors in the ETF will surely lose more money.

USO has already lost 80.41% year to date.

USO firefighting

The turmoil in the oil market has naturally transferred to USO. The fund said it will no longer buy only front-end futures. It now plans to invest a fifth of its assets in second-month futures.

USO has also halted the issue of new shares in the ETF, as it has hit the allowable ceiling. Its application for the issue of new shares is pending with the SEC.

It announced that it will execute a 1-for-8 reverse split of USO shares on April 28.

Were retail investors unwary, or misinformed?

Investors should do their homework and understand the holdings of the ETFs they invest in. They should also be clear about the suitability of the fund in their portfolio.

USO is more suited for hedging and shorting purposes rather than “buy-and-hold.”

Meanwhile, the ETF industry also must educate investors and warn them of potential risks.

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