Friday, January 22, 2016

Year of the OIL

Happy new year readers, and welcome to what's increasingly looking to be a year influenced by oil prices (and perhaps considerations of global warming).

Our first post looks at a phenomenon in the world of robotic, efficient markets: a stark inefficiency.

Yesterday Thursday, January 21, shares of exchange-traded note OIL closed down 17%, so we forgive you if you thought that oil had taken another bludgeoning.  Meanwhile, WTI crude oil futures closed up 11% – its best performance of the year so far.  

OIL is the ticker for the iPath® S&P GSCI® Crude Oil Total Return Index ETN.  Page 1 of OIL’s prospectus states, “The return on the ETNs is linked to the performance of the S&P GSCI® Crude Oil Total Return Index,” so OIL could be expected to go up when oil goes up, and vice-versa.

Below is a table of daily returns from the past 7 trading days ... and we see that OIL isn’t doing such a good job of tracking oil’s performance:

Why did OIL tank yesterday, while oil surged?

The answer, in part, is that a market inefficiency (aka a "whoops") was being corrected, or arbitraged away, finally.  But the story gets more interesting...

It’s all about the ETN’s premium to its daily redemption value – think net asset value (NAV).  The daily redemption value is what an investor could redeem his ETN for by turning over his shares to the ETN issuer (in this case, Barclays).  Since the turn of the year, as the price of crude has plumbed new lows, OIL has not fallen nearly has much as it should have.  While the daily redemption value has fallen over 35% YTD, as of Wednesday’s close (1/20) OIL shares were down less than 12% YTD, driving the premium to 49%!  And yesterday was the day the premium was being "corrected."

The top half of the Bloomberg chart below shows the price history since the beginning of 2015 for OIL’s market price and daily redemption value, while the bottom half shows the market premium.

For perspective, the average premium since issuance of the ETN in 2006 is 0.37% (looking at the average premium from issuance through 1H15 we get 0.06%).  Clearly anything over 10% is wildly aberrational – yet that’s been the case since December.

Where were the arbitrageurs, enforcing price efficiency?  Normally, authorized participants (APs) can create and redeem shares of exchange traded products, which keeps prices in line with NAV.  If there is a large enough price-value divergence, an AP would choose to create shares for the cost of the lower NAV (resulting in a long position) while simultaneously selling shares at the higher market price (offsetting the long position that resulted from creating shares), capturing virtually riskless profits.  Conversely, if the NAV were higher, the AP would buy shares at the lower market price while redeeming shares at the higher NAV.  This mechanism keeps prices close to NAV.

However, according to Dave Nadig at Barclays on 9/15/15 slapped a 50 cent per share fee on the creation of new OIL shares.  At a $5.00 NAV, that amounts to a 10% fee!  (Perhaps Barclays is interested in winding down OIL, instead of expanding issuance.)  Regardless of Barclays' motivations (and possible lack of disclosure of this fee if Nadig is correct), the 50 cent creation fee would only explain part of the premium that had built up.  Wednesday’s closing trading price of $5.51 was still 31% higher than the NAV plus 50 cents!

Wednesday at 2:35 PM, Barclays issued an investor guidance press release saying, “Recently, a material premium has developed in the trading price of the ETNs on the exchange in relation to their intraday indicative value.”  It made no mention of any fees that may have thrown sand in the gears of the price/value enforcement mechanism.   Finally, the following day, traders began to trim the premium paid for OIL shares, causing shares to tumble 17% Thursday, with OIL underperforming its NAV by 23% and crude oil futures by 28%.  After Thursday’s price action, OIL only trades at a 16% premium to NAV, with most of that explained by the $0.50 per share creation fee.

Let us know if you have any intelligence to share on this.

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