For ordinary investors, it was perhaps the most spectacular demonstration of the unique perils of trying to wager on the price of oil.

Last month, the mighty United States Oil Fund, a popular ETF tracking crude, became unmoored as prices fell to unthinkable levels. Leading up the crash, the fund, known by its ticker USO, alone held a quarter of all the soon-to-expire oil contracts in the futures market, alarming regulators and sparking accusations it exacerbated oil’s plunge below zero.

Did USO actually help break the oil market? That we may never truly know. But the episode marked a stunning turning point, not only for the 14-year-old fund, but also commodity ETFs as a whole.

Critics say the debacle has thrown into stark relief questions — some of which were foreshadowed by events a decade ago — about what these exchange-traded funds actually track, if they’re more active than passive, and whether ETFs built around complex derivatives tied to a market as convoluted as oil can be viable for mom and pop investors.

“It’s not just the construction of USO, it’s the ecosystem that allows a product like this to be listed and traded on an exchange,” said Reggie Browne, principal at GTS, a market-making firm.

Granted, just about anyone speculating on a rise in oil prices got hammered.

There are plenty of reasons, unrelated to USO, for why oil fell as far as it did. And USO’s scheduled moves to switch out of expiring contracts over a week before oil crashed below zero kept losses for its holders — which totaled a staggering 75 per cent from March through April alone — from getting even worse.

But extraordinary buying and selling by the fund, one of the biggest players in oil futures, suggests USO may have gotten too big for its own — not to mention the market’s — good.

And that may have turned the fund into something more than the simple oil-tracking ETF that ordinary investors bargained for.

In some ways, those worries have a decade in the making.

In 2009, the Commodity Futures Trading Commission probed USO over large swings in oil prices and concluded the ETF’s futures broker failed to properly disclose certain trades and that the United States Commodity Funds, which manages USO and other commodity ETFs, could be liable.

The firm disputed CFTC’s findings. And a year before, USCF ran into issues with the CFTC over the size of its natural gas positions.

The CFTC’s attempts to police excessive speculation have long faced stiff opposition from a powerful coalition of financial, energy and agricultural firms.

This month, the regulator held another hearing on position limits in the market, but little has been done by regulators or the exchanges over the years to address USO’s popularity with individual investors or its outsize influence in the oil futures market.

Unenviable Position

Those factors came into full view in recent months. The collapse of demand wrought by the coronavirus, and a price war between Saudi Arabia and Russia, sent oil prices down over 66 per cent in the first quarter. All the while, individuals plowed billions of dollars into USO and other oil ETFs, eyeing a rebound.

The selloff prompted many ETFs, including USO, to dump their nearer-dated futures contracts to mitigate losses and move into positions that come due later in the year. (Unlike financial assets, the price of commodities like oil are typically benchmarked to the most actively traded futures contract, which is usually the one closest to expiring.)

Some say those moves, some of which were made at the request of listing venues like CME, accelerated losses and triggered a feedback loop that sent prices tumbling.

On April 20, one day before the May contract on West Texas Intermediate futures expired, the U.S. benchmark settled at -US$37.63 a barrel.

This posed a problem. In a world where sub-zero oil prices are possible, passive ETFs designed to track those prices found themselves in an unenviable position: transform themselves in active funds or go negative and liquidate.

Some were forced to choose the latter. WisdomTree — which shuttered a number of leveraged oil ETFs — explained its decision by saying that if the market moves against you “and you’ve got 3x leverage, the fund is over.”

USO, like many others, effectively turned itself into the former. Its manager said that while it expects the ETF to return to investing in the front-month contract at some point in the future, there is “no guarantee of when, if ever, that will occur.” Investors should expect “continued deviations” in USO’s performance because it won’t be able to track the price of oil properly.

“In some ways, USO has morphed into an active fund, maybe even a hedge fund,” said Eric Balchunas, an analyst at Bloomberg Intelligence. “They’ve abandoned their mission. But, these are wartime decisions. If you are on the front line when a war breaks out, sometimes your protocols go out the window. Your portfolio has to survive.”

John Love, USCF’s chief executive, said he couldn’t comment on anything beyond public disclosures. He said investing in USO “involves risks similar to those involved with an investment directly in the oil market, the correlation risk described in the prospectus, and other significant risks.”

Since debuting in 2006, USO has been a popular choice among individuals, who have few avenues to wager on the direction of oil prices. The retail boom fanned concern the ETF’s fan base didn’t understand the nuances of USO, which has attracted US$6 billion in inflows this year.

Far from a straightforward bet on oil prices, investors not only have to contend with costs incurred from rolling over derivatives when longer-dated contracts cost more, but also the fact that those who hold futures until expiration must take delivery of the actual commodity — whether it’s oil, corn or hogs.

It was fear of getting stuck with physical barrels of oil and no where to store them that led speculators to pay to unload their futures. Hence negative prices.

CME Chief Executive Terry Duffy told CNBC on April 22 his exchange caters to “professional participants” and doesn’t target “small retail investors.”

But the commodity ETFs, which trade on the CME and behave like stocks, are arguably built for just such ordinary investors: A low-fee, tax-efficient way to gain access to markets historically out of reach. That unfettered access was bound to create problems, says Greenwich Associates’ Ken Monahan. One issue is the cost of perpetually switching out of expiring contracts.

Bled Out

“For years, nobody cared that these futures-based ETFs constantly bled out,” said Monahan, a senior analyst covering market structure and technology. “For me, it’s kind of mind-blowing that this is marketed as a retail product.”

John Hyland, who oversaw the launch of USO during his tenure as USCF’s chief investment officer, says he’s heard it all before. Same accusations about USO’s size and influence when oil prices doubled to US$140 a barrel between 2007 and 2008, and the same worries about individuals getting in over their heads.

According to Hyland, USO was actually a net seller of oil futures during the run-up. He also said that because USO’s roll — when it switches over to the following month’s futures contract — is spread out over a number of days, concerns about its impact are overblown. Hyland considers its recent moves little more than “portfolio drift.” The controversy will eventually blow over and the ETF will once again return to tracking front-month contracts.

Regardless, it’s possible the Securities and Exchange Commission is already looking into it, says Jeremy Senderowicz, a partner at law firm Dechert LLP.

The SEC, which regulates equity markets, said in early April it was stepping up scrutiny of leveraged ETFs after getting numerous complaints from individuals. That could now extend to USO after what happened last month. The SEC declined to comment.

“Any time any publicly listed issuer blows up, the SEC is always on the case,” Senderowicz said. “They’re very sensitive to anything that touches retail investors.”